Fed reaches lower range of neutral rate; global growth, event risks need to be watched

Anubhav Sahu Moneycontrol Research Highlights: - With fourth rate hike this year, Fed is closer to neutral rate - 2019 rate hike expectation moderates to two - Global growth moderation and tighter financial conditions key factors - Event risks – trade talk, Brexit needs a closer watch

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As largely expected, the US Federal Open Market Committee raised the Federal Funds rate by another quarter percent to 2.25-2.50 percent – this is the fourth increase this year and the ninth hike in this cycle of interest rate normalization. FOMC’s fund rate dot plot projections for next year have moderated and the expected levels for the longer run level for funds rate has come down 2.8 percent. Together with the Fed Chair Powell’s mentioning that they had reached the lower range of the neutral rate estimates, the implication is that the policy rate is nearing levels where it neither stimulates nor restrains economic growth by changing its interest rate policy.

Seen from that angle, the signals the markets picked up from Powell’s 28^th November speech seem validated.

FOMC has made a downward adjustment in GDP projection for 2018 and 2019 by 10 and 20 bps respectively. There is a similar shift in the Fed’s favoured metric for inflation — the PCE (personal consumption expenditure). In fact the inflation forecast has now seen a second consecutive revision to the downside.

The median Fed funds rate projections have also moderated, bringing them closer to market expectations. The driving factors for this change in stance can be found in deterioration in financial conditions, elevated volatility and moderation in economic growth. The Fed’s September dot plot implied three rate hikes in 2019, while the market expected one rate hike only. Now the December dot plot suggests two rate hikes in 2019 and hence median FOMC participants’ expectations are now closer to the market expectations.

Having said that, the Fed also believes they’ll have one more rate hike in 2020. So in the foreseeable future a total of three rate hikes are now expected (as against the earlier expectation of four rate hikes) before the Fed Funds rate settles near the neutral rate.

Further, the Fed chair has repeatedly mentioned (in his Nov 28^th speech and in yesterday’s press conference) that the policy rate is now closer to neutral rate. Powell underlined yesterday that it has reached the lower end of the neutral rate range estimates.

While the rate hike decision had briefly led to a spurt in US treasury yields, moderation in rate hike trajectory led to correction in longer dated treasury yields. US 10 year yield is hovering around 2.77 percent (vs. 2.81 percent before the policy meet) which is almost pricing in the reduction of one rate hike expectation since Powell’s November speech (3.06 percent on 28^th Nov). The US dollar index remains range bound and is lower than the levels seen in last week of November.

However, the stock market reacted negatively. S&P 500 corrected by 1.54 percent compared to the previous close. Asian markets are also trading lower this morning.

The markets are worried about two things. One, it expected a far more dovish tone with respect to the future rate path and flexibility in the operation of balance sheet unwinding.

Secondly, it is concerned about a slowdown in global growth particularly in the Eurozone, select emerging markets, especially China. When read together with two event risks i.e. the USA China trade talk failure and the possibility of no-deal Brexit, there’s ample room for concern. To put it in perspective, the meeting of the European Central Bank earlier this month, while bringing its quantitative easing programme to an end, observed that the balance of risk is towards the downside. Secondly, the European Commission and UK government have given signals that they are working on a possibility of no-deal Brexit which could have an adverse impact on the region’s economy.

In the last few months, various headwinds for the local markets have dissipated. The Brent Oil price have corrected sharply from $86 to $56 now. The elevated trade war pitch has found a truce for the moment. And now the US 10 year yield has seen a decline of about ~50 bps within two months. This is constructive for the market, provided of course the driving force for this development is not the slowdown in global growth.

Back home inflation data has been subdued partly due to lower food inflation. However, lower crude provides a positive context which along with signs of improvement in capex cycle is comforting. Having said that moderation in global growth needs to be watched and the event risks (trade talks and Brexit) ensures that volatility would remain at an elevated level.