Moneycontrol Pro Weekender: Doubting the Fed

Dear Reader,

Keeping up the fine old traditions, we at Moneycontrol Pro have peered into crystal balls, read the tea leaves, consulted the stars and experts, and pored over charts to foretell what 2023 will bring for the markets, for business and for the economy. The most important method of fortune-telling in 2023, however, would call for inspecting the entrails of Fed chair Jerome Powell, a course of action denied us, no doubt much to the dismay of market punters aggrieved by his policies. Fortunately, we have a more conventional alternative available, in the minutes of the Fed meetings.

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And the minutes of the last Fed meet are rather hawkish. They talk of the US labour market remaining very tight, with the unemployment rate near a historically low level, robust payroll gains, a high level of job vacancies, and elevated nominal wage growth. Participants at the Fed meeting stressed that “it would take substantially more evidence of progress to be confident that inflation was on a sustained downward path”. The minuets add, “A number of participants emphasised that it would be important to clearly communicate that a slowing in the pace of rate increases was not an indication of any weakening of the Committee’s resolve to achieve its price- stability goal or a judgment that inflation was already on a persistent downward path.”

But here are perhaps the two most important points in the minutes. One of them is: “No participants anticipated that it would be appropriate to begin reducing the federal funds rate target in 2023.’’ The second one is: “Participants noted that, because monetary policy worked importantly through financial markets, an unwarranted easing in financial conditions, especially if driven by a misperception by the public of the Committee’s reaction function, would complicate the Committee’s effort to restore price stability.’’

The Chicago Fed’s Adjusted National Financial Conditions Index shows that it is now at the same level as it was back in early March 2022, before the Fed’s rate hikes began. Fed members are understandably glum.

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As for the assertion that the policy rate won’t be reduced in 2023, the CME Group’s Fedwatch tool shows that according to the markets, the probability of the Fed Funds rate being 450-475 basis points or lower at the end of this year is 53 percent. That’s a 25 basis point drop from the peak rate of 475-500 basis points expected by the markets. In other words, the market simply doesn’t believe the Fed. It is this scepticism that has been the reason for the markets being supported, and for the periodic rallies. Ironically, a rally in the stock markets loosens financial conditions further, which the Fed is keen to avoid.

Why does the market doubt the Fed’s resolve? One, it’s difficult to forget the experience of the last couple of decades, when the Fed cheered on the markets. Two, there’s a view that growth will crater, leading the Fed to rapidly pivot. And three, inflation will come down rapidly and the Fed will have no reason to maintain a tight money policy. Base effects will magnify the fall in inflation. Jefferies’ Chris Wood summed up this view in his Greed & Fear newsletter: “If CPI rises by 0.1 percent MoM for the next six months (i.e., a repeat of what happened in November), CPI falls to 3 percent YoY in May and 1.7 percent YoY in June. If month on month increases are 0.2 percent, CPI still falls to 3.6 percent and 2.4 percent YoY in May and June. This is why there is a much better chance of a U-turn by the Fed than currently perceived to be the case by markets….”.

Continuing with the crystal ball gazing, here is Ruchir Sharma’s investor guide to 2023—from peak dollar to better TV to blue birds. Blue birds, he says, are rare unforeseeable events that bring joy, such as a breakout of peace in the Ukraine. As the poet Charles Bukowski wrote, “There’s a bluebird in my heart that/wants to get out/but I’m too tough for him.”

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Our columnist Ajay Bagga called the Year of the Rabbit one of recession, recovery and rebound. This FT story, free to read for MC Pro subscribers, talked about business trends, risks and people to watch in 2023. We wrote about what could surprise the markets this year, while columnist Vijay Bhambwani discussed why markets may rally this month. The Eastern Window explained why Chinese stocks may be poised for a recovery.

For a less upbeat view on central bank policy, read this story on the IMF’s Gita Gopinath urging the Fed to stay the course this year. And for the unsettling view that we could see a fundamental reset in the global economy and markets, please read this article.

What about the Indian markets? The PMI data show that momentum in the Indian private sector is far ahead of other countries. Indeed, we made the point that if it is so good, there’s no need for any stimulus in the forthcoming Indian Budget. There are many other indications of a robust recovery. Commercial vehicles sales continue to maintain momentum, driven by a pick-up in economic activity. Systemic credit growth is strong and deposit growth too has started improving. The share of bank credit to large industry has gone up in the last three months, indicating an industrial recovery. The recovery in the thermal power sector is on track despite the thrust on clean energy.

Nevertheless, India will not remain immune to global headwinds. Ananya Roy points out the disparity between the manufacturing PMI data and the IIP numbers and urges caution. Two-wheeler sales are stuttering. Marico’s update shows that rural demand continues to lag. The government is facing steep cost overruns in infra projects. Core sector growth in December is merely a statistical illusion.

As a research note by Nikhil Gupta from brokerage Motilal Oswal points out, nominal GDP growth in 2023-24 is likely to be much lower than for the current fiscal. This will lead to slower corporate sales growth and weaker bank credit expansion. The note says, “Overall, slower GDP growth could have serious implications for the macro economy, and many of them are likely to play out over the next 12-18 months.” My colleague Abhijit Dutta has underlined the impact of lower nominal GDP growth on GST collections in 2023-24.

Coming to the Union Budget, IndusInd Bank chief economist Gaurav Kapur has cautioned about India’s elevated twin deficits, while the IMF has called for fiscal consolidation. Taking all these factors into consideration, Hemant Kanawala, the head of equities at Kotak Mahindra Life Insurance Company, says Indian markets are headed for consolidation. Our personal finance story predicts a clearer path for both equity and debt in the second half of the year.

There is another reason for scepticism about the Fed’s claim that it will not ease monetary policy this year -- its record of projecting the Fed Funds rate doesn’t inspire much confidence. In December 2022, it projected a Fed Funds rate of 0.9 percent at the end of 2022 — the rate is now at 4.25-4.5 percent. And, before the pandemic years, in December 2018, it projected a Fed Funds rate of 2.9 percent at the end of 2019 — the actual rate in December 2019 was 1.5-1.75 percent.

Be that as it may, the market is desperately telling the Federal Reserve, in the immortal words of Rihanna’s hit song: ‘Please don’t stop the music’. When she sings ‘DJ, let it play’, could she possibly be referring to Dear Jerome?

Incidentally, that song was released in September 2007, a year before the music stopped.

Cheers,

Manas Chakravarty

Here are some of the stories and insights we published this week, apart from our technical picks in the equity, forex and commodity markets:

Stocks

Indian Energy Exchange

Is there an opportunity to invest in the chemicals sector?

Sugar sector in a sweet spot

Kirloskar Ferrous Industries

Why AMC stocks are under pressure

Mrs Bectors Food Specialities

Zee Entertainment