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Fed delivers on rate hike with improved growth outlook; here's what we make of it

In the June policy, the Fed chose to concentrate on the US' economy rather than be distracted by emerging market woes

Neha Dave @nehadave01

As was widely expected, the Federal Open Market Committee (FOMC) on Wednesday hiked the fed funds rate by 25 basis points, moving the target range to 1.75-2.00 percent. This was the seventh rate hike announced by the FOMC since December 2015.

Dot plot turns hawkish with a potential fourth rate hike

In addition to the rate hike, the Federal Reserve's dot plot, which signals the future path of interest rates, suggested that the central bank was planning 4 rate hikes this year, instead of the 3 rate hikes forecast earlier.

With two rate hikes already announced, we can see two more in 2018.

The dot plot showed that eight fed policy makers expected 4 or more 25-bps rate increases in 2018. In comparison, seven officials expected 4 or more rate hikes at the time of the previous forecast in March. So the median forecast has now edged up from 4 rate hikes from 3 earlier.

The median forecast for 2019 remains at three additional 25-bps hikes, with one hike expected to come in 2020.

Fed projections

US inflation measures on the rise as economy operates at full capacity

Consistent with a more aggressive near-term rate hike path, the FOMC median economic projections revealed a lower unemployment rate and higher inflation rate through 2020 than was forecast in March.

US consumer price inflation rose 0.2 percent month on month and 2.8 percent year on year in May 2018. Out of all the major inflation measures the Fed watches, only the core personal consumer expenditure (core PCE) deflator was below 2 percent.

Unemployment of around 4 percent is at a multi-year low. Payrolls growth accelerated from an average monthly increase of 182,000 in 2017 to 207,000 a month in 2018 so far.

There is also growing evidence of wage pressures as the jobs market is going from strength to strength. Having said that, average hourly earnings growth is still fairly soft at 2.7 percent.

However, with $1.5 trillion of tax cuts, real disposable incomes of households are expected to increase, which in turn will push inflation upward.

Improved growth outlook

The forecast for real GDP growth for 2018 was revised to 2.8 percent from 2.7 earlier.  The FOMC also upgraded its assessment of economic growth to "solid" from "moderate", and noted that since the last meeting, household spending has picked up and unemployment rate has declined.

The clear and precise communication signaled the central bank's confidence about US' current economic growth.

How could the policy impact US' economy, and fixed income and equity markets?

US economy

Tighter monetary policy ought not to have a significant impact on the US economy in the short term, but higher intermediate and long-term interest rates (a consequence of rising short-term interest rates) could dampen economic growth over time.

There are no signs of a recession on the horizon, though the yield curve has flattened with the gap between 2 and 10-year bond yields narrowing to 37 basis points.

Fixed income markets

Bond yields will continue to head higher, albeit at a gradual pace, as a mix of solid economic growth and rising inflation paves the way for normalisation of the central bank's policy.

But the bigger debate is on the quantum of the upward move in yields. The stance on monetary policy remains accommodative. We think there is some time before the policy hits the neutral rate, the rate that neither raises nor lowers the level of demand in the economy.

Even after Wednesday's hike, the real rates in US are still negative. Hence, we can see the US 10-year yield to enter uncharted territory above 3 percent in medium term. As such, we can expect a reasonably choppier conditions for US fixed income markets.

Fed real rates

Equity markets

Higher yields give rise to yet another question. Will the rising yields derail the rally in US stocks? We don't think so.

While rising yields are generally considered to be negative for equity markets, the current yield on the US 10-year treasury, which is around 3 percent, doesn't take any lustre away from stocks. With the equity risk premium (difference between earnings yield and real bond yields) at around 5 percent, stocks are still more attractive than bonds.

The rally in the US equity market entered its tenth year in 2018. As such, US stocks are richly valued on some metrics. The 12-month forward P/E ratio for the S&P 500 is 17.3, which is more than the 5-year historical average of 16.2 and the 10-year average of 14.4.

US stocks are relatively expensive, but as long as corporate earnings are going up, they will have room to rise more. We expect them to be well supported by robust earnings growth of over 18 percent for 2018.

Impact on India

Rising US bond yields adversely impact overseas inflows into emerging markets like India. The yield on India's 10-year has spiked by 70 bps over the last couple of months.

This means that despite the rise in US yields, the spread/differential between US and India's 10-year bonds has been maintained at around 4.5-5 percent, which is attractive.

However, India is still not attracting foreign flows even after raising the limits for foreign investment in government securities. The key concern for foreign investors is the currency risk because a depreciating rupee can reduce their unhedged returns significantly.

Shrinking supply of the US dollar in the market has led to the dollar gaining in strength, and as we know, a strong dollar feeds on itself. The dollar appreciation widens India's current account deficit as the country happens to be a net importer. It also translates to higher inflation.

As a result, RBI is compelled to raise its repo rate in response to higher US yields, amid an evidently-tightening dollar liquidity situation.

Higher rates in India can derail economic growth, which still is not on strong footing and can be negative for the equity market. It is worth noting that higher rates in US are stemming from higher anticipated inflation, which is demand-pulled.

In contrast, high inflation in India is majorly cost-pushed (imported inflation).

Hence, the rising US yield makes the RBI's job more difficult as it strives to control inflation, and maintain a stable currency without adversely impacting the growth.

What could be the policy impact for other economies?  

A number of emerging economies may face difficulties as the Fed continues to raise short-term rates and unwind its balance sheet. Consequently, there have been calls from some quarters for the Fed to consider the implications for the broader global economy, while determining its policy stance.

For instance, RBI governor Urjit Patel, said earlier this month that the US Fed must slow down the pace of trimming its balance sheet to limit the effects of the lack of supply of dollars in the market.

He argued that the Fed unwinding its balance sheet, and the substantial increase in the number of US treasury issuances to pay for tax cuts, has reduced liquidity and has pushed the dollar up.

This kind of situation proves to be a "double whammy" for emerging markets as they witness a sharp reversal of foreign capital flows, as well as currency depreciation.

However, in the June policy, the Fed chose to concentrate on the US' economy rather than be distracted by emerging market woes.

For more research articles, visit our Moneycontrol Research page
First Published on Jun 14, 2018 08:05 pm
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