US Federal Reserve’s Federal Open Market Committee (FOMC) is meeting on December 13-14 to decide on the magnitude of the next rate hike. The Fed has increased interest rates by 375 basis points so far in 2022; the most recent four rate increases were each of 75 basis points.
US Fed rate hikes are directed towards bringing inflation to under 2% from the current level of 7.7%. And, the first signs of inflation cooling down were seen in October’s US CPI data released on November 2. From a high of 8.3% in August, annual inflation fell to 8.2% in September and settled much lower at 7.7% in October.
On the back of lower inflation numbers for October, Fed’s Powell was quick to send a clear message to the stock market– the pace of rate hikes may slow down but the terminal Federal funds rate could be much higher than expected.
November 30 update: Speaking at the Hutchins Center on Fiscal and Monetary Policy on the outlook for the economy and the changing labor market, Federal Reserve Chair Jerome Powell said that smaller interest rate increases are likely ahead even as he sees progress in the fight against inflation as largely inadequate. “Jerome Powell indicated that FED is on track to raise interest rates by 50bps at its next meeting, stepping down from an unprecedented series of four 75 bps rises aimed at combating high inflation,” says Mitul Shah, Head of Research at Reliance Securities.
The pace of rate hikes may slow down but the terminal target rate may exceed the levels of previous expectations. “We continue to expect a 50 bps rate hike in mid-December 2022 FOMC meet and a terminal Fed Fund target rate in the band of 4.75-5%,” says, Deepak Agrawal, Chief Investment Officer, Debt Fund, Kotak Mahindra Asset Management Company.
A low-interest rate environment is conducive for equities to perform as a fall in borrowing costs boosts corporate earnings. New capital expenditure emerges in the economy leading to a boost in stock valuations.
It was already expected that the Fed will climb down from 75 bps to a lower rate of 50 bps. The Fed FOMC minutes released recently also signaled a slowdown in the pace of rate hikes. In early November, Jerome Powell had also said that it might be better to reduce the rate of rate increases as soon as the next meeting or the one after that.
Following October’s surprising inflation results, the markets may be sensing a 50 basis point or possibly a 25 basis point rate hike, especially if the November US CPI data likewise reveals a further decline in inflation.
José Torres, Senior Economist at Interactive Brokers says, “Expectations of Fed tightening moved down significantly this morning, with the market now strongly expecting a 25 basis point (bps) hike at the December meeting. Odds of a 50 bps hike in December moved down to 14% while odds of a 25 bps climbed to 86%.”
However, there needs to be sustained fall in inflation numbers, especially the core inflation before Fed chooses to go easy on rate hikes.”As optimism about the inflation war grows, some investors have become hopeful that the central bank won’t have to overshoot its rate hikes and instead drive the economy to a soft landing rather than a recession, but in my view, the stubborn nature of decades-high inflation, entrenched in the highly inelastic services segments, makes that outcome unlikely,” adds Torres.
Analysts are of the view that the pricing pressure on the lead indicators will show clearer indications of weakening at the December FOMC meeting, but weaker activity data may be enough to persuade the Fed to act more cautiously.