The US Federal Reserve hiked interest rates by three quarters of a percentage point on Wednesday (June 15), its most aggressive move since 1994, in a bid to tame runaway inflation.
The hike in rates by the Fed, the third since March, comes after inflation in the US surged unexpectedly last month. More importantly, the US central bank has signalled equally-large hikes later this year, which could potentially dent the already wobbly investor outlook across markets.
After the conclusion of a two-day Federal Open Market Committee (FOMC) meeting on Wednesday, the central bank chair Jerome Powell indicated that the Fed would increase its key interest rate by three quarters of a percentage point to a range of 1.5 per cent to 1.75 per cent.
Forecasts released after the meeting recorded officials saying they expected the rate the Fed charges banks to borrow from it to zoom to 3.4 per cent by the end of the year.
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What is the import of the Fed’s signaling?
While markets have largely factored in the reversal in the Fed’s policy stance, there are renewed concerns about the pace of the hike given that the US central bank is now under renewed pressure to tame runaway inflation as prices in the world’s largest economy rose at their fastest rate in 40 years during May.
There are now clear indications that the US central bank would be far more aggressive in its intensity of rate hikes, going by the guidance offered by Powell.
Runaway inflation is being seen as a political headwind for President Joe Biden ahead of the November midterm elections.
Biden had said earlier this year that it was “appropriate” for Powell to adjust the Fed’s policies. And congressional Republicans, according to an AP report, have endorsed Powell’s plans to raise rates, providing the Fed with rare bipartisan support for tightening credit.
Powell reaffirmed the view at the last review meeting that policymakers are convinced the American job market is robust enough to let go of the ultra-low interest rates.
On Wednesday, Powell said the US is well poised to handle higher rates, pointing to still robust job growth. But projections released by the Fed show officials expect economic growth to slide to about 1.7 per cent in 2022, a full percentage point lower than the forecast they had made in March.
How does this impact global markets?
Traders across markets have been looking for signs that the Fed might be more aggressive about rolling back the stimulus that has been feeding stock market gains across geographies. The new projections are being seen as a definitive move to frontload the reversal of the central bank’s expansionary monetary policy put in place in early 2020 to invigorate the American economy amid the Covid-19 outbreak.
Part of this support was in the form of an extraordinary bond buying programme, which was intended to bring down long-term interest rates and catalyse greater borrowing and spending by both consumers and businesses.
What are the concerns at this stage?
The Fed’s announcement has come amid criticism that the US central bank has fallen behind the curve on inflation.
Analysts were quoted by Reuters as saying that they felt the Fed is now struggling to catch up, after Powell and other Fed officials maintained till early this year that inflation in the US was merely a temporary problem related to supply chain issues.
Prices have spiked since then, partly due to external factors that include the war in Ukraine and the continuing Covid-19 shutdowns in China’s key manufacturing hubs.
The Fed, which cut rates to support the economy when the pandemic hit in 2020, has already increased rates this year, by 0.25 percentage points in March and another half a point in May.
At the time, Powell had reiterated that they were not considering sharper rises. But inflation numbers released on Friday (June 10) showed US inflation rising to 8.6 per cent in May — the fastest pace since 1981, prompting the latest round of hikes.
“It is essential that we bring inflation down,” Powell said, acknowledging that a 0.75 percentage point rise was “unusually large.”
“Inflation has obviously surprised to the upside over the past year and further surprises could be in store… We therefore will need to be nimble.”
The Dow Jones Industrial Average, after an initial slide, rose strongly during Powell’s post-meeting news conference before paring gains somewhat by the close of trading on Wednesday. In India, benchmark indices were up in opening trade on Thursday (June 16), partly because the markets had factored in the increased rate hike after the US inflation data for May was released last week.
The latest hike is also being seen as an acknowledgment of the Fed’s resolve to fight the inflation problem, after being seen as having fallen behind the curve in taming prices.
Why are these signals from the Fed important?
Like other central banks such as the Reserve Bank of India, as the US Fed conducts monetary policy, it influences employment and inflation primarily by using policy tools to control the availability and cost of credit in the economy.
The Fed’s primary tool of monetary policy is the federal funds rate, changes in which influence other interest rates — which in turn influence borrowing costs for households and businesses, as well as broader financial conditions.
Additionally, the bond buying programme, also known as quantitative easing, was put in place in 2020 as an extraordinary measure to help the financial markets and the economy counter the impact of the pandemic.
This bond was an unconventional monetary policy tool (that was buying during the global financial crisis as well), which using the central bank purchases longer-term securities from the open market in order to increase the money supply and incentivise lending and investment. Buying these securities augmented the supply of new money in the economy, and ended up dampening interest rates, while also expanding the central bank’s balance sheet.
On Wednesday (June 15), the Fed halted the process of pumping the proceeds of an initial $15 billion of maturing Treasuries back into the American government debt market, the first time it has done so since it kicked off its bond-buying program in early 2020. This effectively signals the move by the US central bank to shrink its expanded $9 trillion balance sheet.
The Fed is not alone in its intention to hike rates.
On Thursday (June 16), the Bank of England is expected to announce its fifth rate rise since December, pushing its benchmark rate above 1 per cent for the first time since 2009. Australia, Brazil, and Canada also have raised rates, while the European Central Bank has indicated that it could hike over the next couple of months.
How do rate cycles work?
When interest rates go up in an economy, it becomes more expensive to borrow; so households are less inclined to buy goods and services, and businesses have a disincentive to borrow funds to expand, buy equipment or to invest in new projects.
A consequent lowering of demand for goods and services ends up depressing wages and other costs, in turn bringing runaway inflation under control. Even though the linkages of monetary policy to inflation and employment are not direct or immediate, monetary policy is a key factor in tackling runaway prices.
Theoretically, a signal to hike policy rates in the US should be a negative for an emerging marketoretically, especially from a debt market perspective.
Emerging such as India tend to have higher inflation and, therefore, higher interest rates than in developed countries. As a result, investors, including Foreign Portfolio Investors, tend to borrow in the US at lower interest rates in dollar terms, and invest that money in the bonds of countries such as India in rupee terms to earn a higher rate of interest.
What will be the impact on other markets, including India?
A hike in rates in the US could have a three-pronged impact.
When the Fed raises its policy rates, the difference between the interest rates of the two countries narrows, thus making countries such as India less attractive for the currency carry trade.
A high rate signal by the Fed would also mean a lower impetus to growth in the US, which could be yet negative news for global growth, especially when China is reeling under the impact of a real estate crisis.
Higher returns in the US debt markets could also trigger a churn in emerging market equities, tempering foreign investor enthusiasm.
There is also a potential impact on currency markets, stemming from outflows of funds.