US' interest rate policy remains on course despite temporary shocks from hurricanes

Federal Reserve Chair Janet Yellen delivers semiannual monetary policy testimony during a House Financial Services Committee hearing on Capitol Hill in Washington, U.S., February 15, 2017. REUTERS/Yuri Gripas - RTSYT7E

Anubhav SahuMoneycontrol research

FOMC (Federal Open Market Committee) in its policy statement, released yesterday, reposed confidence in the improvement of the US economy.  Unperturbed by the recent impact of hurricanes and soft inflation, the Fed guided to both balance sheet unwinding and a rate hike by the end of the year. Fed’s continued stance on the policy rate normalisation is apparently positive for the US dollar, particularly with respect to emerging market currencies.

Signaled further policy rate hike later this year

FOMC mentioned that the labour market remains solid (higher job gains and the unemployment rate staying low), household spending is expanding moderately and the growth in business fixed investment has picked up in recent quarters.

As per the Fed dot plot, median end-2017 projection is 1.375 percent implying one more rate hike of 25 bps expected by the end of current year. Market odds for a December rate hike has increased to 60 percent probability (from 50 percent earlier). For the year 2018, the median target is 2.125 percent, unchanged from the last meeting, implying three rate hikes of 25 bps each.

Chart: Fed policymakers policy rate projections

Source: Federal reserve, FT

USD rallies, US 10-year yield firms up

The dollar index, which was trading lower (91.67), moved up (92.35 currently) after the Fed statement and press conference. US 10-year yield as well edged up from 2.23 percent to 2.27 percent underlining the monetary policy normalization on course.

Lower long term policy rate

Source: Federal reserve

From a longer-term perspective, the FOMC expectations are for a lower federal fund rate at 2.75 percent vs. 3 percent in June projection. This can be seen as a reflection on the structural changes in the economy guiding for lower real rate for long term (0.75 percent=2.75 percent-2 percent inflation rate).

Hurricane effect transient

FOMC mentioned that storm-related disruptions and rebuilding will affect economic activity in the near term, but past experience suggests that the storms are unlikely to materially alter the course of the national economy over the medium term. Though it might push inflation temporarily which would also be impacted by the recent rise in oil and oil derivatives prices.

However, Fed’s 12 month inflation projection is expected to remain below 2 percent. In fact FOMC’s median projection for 2018 inflation is tweaked lower to 1.9 percent (vs. 2 percent) indicating that inflation would climb to a long-term rate but with a delay. At the same time the Fed emphasised that near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely.

Source: U.S. Bureau of Economic Analysis

Unwinding of balance sheet

The Federal Reserve, in an unanimous decision, decided to commence normalizing the balance sheet from the next month. This marks the last leg of unwinding of QE programme which had quadrupled the balance sheet to USD 4.5 trillion. The Fed announced that it will begin reducing bond reinvestments, starting by USD 10 billion per month and growing to USD 50 billion. This would continue till the central bank's overall balance sheet falls to the level of USD 2.5 to USD 3 trillion. Market participants expect the unwinding to be a series of gradual adjustments over the years.

Source: US Federal Reserve

Overall the Fed meeting re-emphasized that policy normalisation is expected to remain on course. While balance sheet unwinding would start in October, the case for another rate hike in December is also likely. Key economic indicators are strengthening and effects from hurricanes are expected to be transient.

While the backdrop is positive for USD, as a corollary, reversal in recent EM currency appreciation cannot be ruled out in the near future.

Inflation data remains pivotal for the Fed policy framework but is expected to rise only gradually. Nevertheless, for currency watchers it remains a key monitorable.

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