Three major central banks announced their policy decisions last week. While all three, the European Central Bank (ECB), Federal Reserve, and the Bank of England (BoE), kept their policy interest rates unchanged, their outlook for growth and inflation differed extensively. Fed FOMC sounded more dovish, whereas the ECB and the BoE reiterated their positioning of a higher-for-longer stance.
Both the ECB and BoE have highlighted risks to growth and inflation from rising geopolitical and trade fragmentation, rise in energy prices, and extreme weather conditions driving up food prices. Additionally, household inflation expectations could be sensitive to rising wages if higher corporate profits translate into increased labour demand.
Hence, the dichotomy between the US Fed’s dialing down of its hawkish stance of 'higher for longer' replaced with benign guidance of three rate cuts in 2024, instead of two, and the continued hawkish stance of the ECB and the BoE is pivoted on the significant difference in their assessments.
Unlike the other two, the Fed’s confidence emanates from its belief in attaining a soft-landing trajectory that achieves price stability without any economic disruption.
However, the Fed’s guidance and projections since the post-pandemic expansion have seen significant errors and recasts, with the current guidance seemingly veering back to its misplaced transitory inflation thesis of 2021.
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While factors highlighted by both the ECB and the BoE are germane to the US economy as well, there are US-specific additional facts that deserve attention.
a) The US labour market is still in disequilibrium: The unemployment rate at 3.7 percent remains close to historical lows and labour demand/supply ratio at 1.34x is still high by historical standards.
b) Risks to upward revision in inflation projections continue remain: Reduction in the Fed’s inflation projection for 2024 at 2.4 percent is guided by three-month average month-on-month changes in core PCE, including the abnormal dip in August 2023. A higher monthly rise than 20bp might lead to an upward revision in the projected inflation for 2024 and 2025.
c) The projected US GDP trajectory remains above potential: The upgrade of real GDP growth to 2.6 percent for 2023 and 1.4 percent for 2024 implies 2024 real GDP to be 2.4 percent higher than projected at the start of 2023 and 0.4 percent higher than Fed’s long-term trajectory growing at 1.8 percent. The projected positive output gap and tight labour market portends upside risk to inflation.
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d) Consumption remains above trend: The household situation remains strong with the real personal consumption growth at 2.2 percent YoY trending above the post-Covid potential trend by around 3.0-3.2 percent.
A combination of a falling savings rate and an above-trend consumption could be the reason for the recent rise in labour participation. However, with a strong demand situation, the easing of financial conditions with premature rate cuts could lead to a resurgence of inflation as the impact of the rising wealth effect from asset price resurgence on demand could nullify the positive labour supply responses. This would intensify the positive demand gap and challenge the achievements towards price stability objectives.
Important monetary policy considerations for 2024 will also be the US presidential elections, which may imply political overtures. Fed’s monetary policy conduct can get complicated if it turns accommodative toward rising fiscal deficit and public debt. History of the early 1970s tells us that erring on the side of accommodation when the economy is still above trend can cause inflationary impulses to relapse, specially in the current context of rising protectionism, and declining Chinese savings.
The direction of these factors will show up during 2024 and does not portend a unidirectional buoyancy. But for now, the markets are soaking in on the Asynchronous Pivot with the Fed being the outlier.
The dominance of Fed’s communique has overwhelmed the markets with significant triggers across the markets, including equities, rates, and currencies.
From India’s standpoint, the market liquidity momentum has experienced a second trigger following the recent States election results. The drop in the US risk-free rate (10-year at 3.9 percent from 5 percent in October 2023) has pushed up valuations, particularly for IT (+8 percent), Metals (+5 percent), and Realty (+3.8 percent) relatively higher than for Nifty (2.3 percent).
From the macro-cycle standpoint, underlying the strong headline real GDP growth of 7.7 percent in 1HFY24, India’s core growth is modest, around 3.0-3.5 percent, i.e., aligning with household consumption and income (76 percent of GDP). Consequently, corporate results are likely to show feeble topline growth, a rise in inventory, and lingering margin gains, which may be transient.
In the context of the latest global developments, our overweight view on the IT sector needs to be stepped up. While valuations for bank and metals stocks tend to benefit from weaker USD, as triggered by a dovish Fed, we remain cautious about their business outlook along with onset of the retail NPA cycle.
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