Much as it was on expected lines, the US Federal Reserve’s decision to hike the Fed funds rate by yet another 25 bps was not entirely a non-event for the markets.
Much as it was on expected lines, the US Federal Reserve’s decision to hike the Fed funds rate by yet another 25 bps was not entirely a non-event for the markets. With all eyes on recently-inducted Fed Chair Jerome Powell, investors had been keenly awaiting his and the FOMC committee’s stance on several key issues including: (a) the Trump government’s double fiscal policy push (USD 1.5 Trn tax overhaul and USD 300 Bn fiscal spending plan); (b) the newly-introduced US import tariffs on steel and aluminium and its likely repercussions on global trade dynamics; (c) still-loose financial conditions and discernible financial risks; and (d) most importantly, the net impact of the melange of these factors on ongoing growth recovery, sub-2% target core PCE inflation and future policy rate trajectory.
While the FOMC language and projections did present a hawkish undertone, the much-tracked Fed dot-plot continued to reflect three rate hikes by the central bank in 2018, surprising markets which had now begun to factor-in four or more rate hikes. Previously, the January FOMC minutes had signalled macro-optimism, indicating that a number of committee members had already raised their growth forecasts and there could be upside risks to growth on the back of fiscal stimulus. In their latest public commentary, Fed officials Powell and Brainard had echoed that macro “headwinds could be turning to tailwinds”, while Quarles suggested that it was “quite sometime since the economy looked so favourable”. To this extent, in yesterday’s meeting, while the FOMC raised GDP estimates and reduced unemployment projections for 2018, interest rate projections remained unchanged.
Probing deeper into the ongoing macro issues facing the US economy and to some extent discounting markets (which are known to typically overshoot in such times of macro-uncertainty), understanding the US rate-setters’ wait-and-watch monetary policy mode is quite straightforward.
First, much of the anticipated boost to growth and inflation from the recently-announced fiscal policy stimulus could have a transitory element. In the post-policy conference, Fed Chair Powell acknowledged that while the impact on US macros would be positive, it was still “uncertain” to some extent. Therefore, for now, the central bank has kept its inflation estimates unchanged for 2018. In any case, even if inflation temporarily rises above the 2% target, the US Fed has repeatedly highlighted that the inflation goal is “symmetric” (that is, it is as willing to tolerate periods of inflation slightly below the 2% target as it is periods when it rises slightly above the target), implying it may not react to rising inflation too fast, too soon. Resultantly, 2018 FOMC rate projections remain unchanged at this juncture.
Second, the upside to inflation of the US administration’s move to implement import tariffs on the steel and aluminium industry could also be temporary, as the initial increase in import prices affect demand and growth. The net impact to inflation and growth remains unclear, as exemptions and bilateral trade agreements are underway for several trade partners such as Canada, Mexico, EU and Australia. Market estimates suggest that US economic growth could slow by 0.2-0.3 percentage points as a result of import tariffs, which in turn could thwart the pace of rate hikes.
Third and on a more technical note, waiting for future monetary policy meetings will have equipped the US central bank with data on H12018 inflation readings. More specifically, statistical effects have played a role in suppressing US inflation since 2017, when a telecom major decided to offer customers unlimited data at a flat rate- a factor also acknowledged by the Fed in its past commentary. Upside surprises to upcoming H12018 inflation data releases could strengthen the argument for faster rate hikes in 2H2018. Additionally, by the time, the playout of the Phillips curve (the upward impact of tightening labor market on wages; which the US Fed continues to await) may also begin to show in inflation and wages data, in turn strengthening the case for faster rate hikes.
Notwithstanding the above-mentioned factors, the Fed’s decision to maintain a measured approach to rate hikes makes greater sense when viewed on a broader scale. For instance, other major global central banks too have decided to undertake a slow and steady approach as they ready to pare back monetary stimulus. Monetary policy language of the European Central Bank remains balanced even as it prepares to hike rates in 2019, while Bank of Japan officials continue to enlist economic risks even as they acknowledge positive domestic macros. Rather than disrupt markets (ala Taper Tantrum 2013), central banks appear to have implicitly colluded and decided to digest accusations of being backward-looking than disrupt a fledgling macro recovery. Herein, the US Fed is expected to maintain the lead, but is expected continue to tread with caution. More clarity would be obtained by summer.
Prakriti Shukla is an independent researcher based in New York. She has previously worked with Yes Bank and Goldman Sachs in the capacity of an economist. Views expressed are the author’s own.