What the US Fed statement means for the RBI?

When the Fed statement was presented by the US Federal Reserve late on 14th June 2023, the expectations were already quite high about a pause in interest rates. That is exactly what the Fed announced. Fed called a halt and maintained the interest rates at 5.00%-5.25%. The thinking of the Fed was that it had raised rates by 500 basis points and the inflation was showing a lot of promise. It was, perhaps, time to allow the lag effect of all these rate hikes to further cool the inflation before taking up a fresh view. However, the Feed has added a rider. Even as it paused on rates in June, the Fed has made it clear there would be another 2 rate hikes of 25 bps each in this year. Also, it has ruled out any rate cuts in 2023 but it does expect rate cuts up to 100 bps in the year 2024.

What the CME Fedwatch says about rates trajectory

The CME Fedwatch captures probabilities of rate levels after each Fed meet over next 1 year and is the implied probabilities based on Fed futures prices. It is constantly changing.

Data source: CME Fedwatch

What does the above CME Fedwatch table say? Firstly, there is a lot of convergence now between what the Fed is saying and what the markets are indicating. Just about 3 months back, the markets expected aggressive rate cuts in 2023 and 2024. Now the markets have toned down and are fine tuning their expectations according to what the Fed has been stating. Now the expectations are about a 25 to 50 bps rate hike in 2023 and a 75 to 100 bps rate cut in year 2024. Clearly, the markets have understood that it does not make sense to second guess the statements of the Fed, since the Fed takes its communication quite seriously. In short, the moral of the story is that the CME Fedwatch, in the last 3 months, is increasingly inclined towards believing what the Fed says.

Highlights of the Fed statement in June policy

Here are some important highlights of what the Fed said in its policy statement.

• Fed has paused and has made it crystal clear that it is just a pause and nothing else. It has cautioned markets another 50 bps rate hike was on the anvil in 2023 and it would most likely happen in 2 tranches. However, the Fed also hinted at 100 bps rate cut in 2024. So, it is not entirely hawkish.
   
• The fed rate pause will allow the trickle-down effect of rate hikes to be factored into inflation. Also, inflation for May fell to 4%, although the Fed looks at PCE inflation rather than consumer inflation. Above all, the banking crisis triggered by Silicon Valley Bank and Signature has also tightened consumer credit to a great extent.
   
• On the rate hikes, the Fed has been often accused of starting too late. It does not want to be too early or too late in turning the other way. To begin with, it will wait till inflation is close to 2% and then reverse its rate strategy. That will ensure that the GDP impact can be avoided.
   
• Apart from inflation, unemployment is an important data point that the Fed looks at. In the recent month, unemployment is up from 3.4% to 3.7% due to tightness in the job market. additionally, the Fed expects unemployment rate to spike to 4.1% in 2023, which is largely in sync with the premise of tightening.
   
• Now it is not just the headline inflation that Fed is worried about but also the PCE inflation and the core inflation. Also, it wants to be doubly sure that a surge in employment does not nix the potency of the rate hike program. Core inflation at 5.3% continues to remain a challenge for the Fed.
   
• In the policy statement, the Fed indirectly gave a hint of the terminal rates at around 5.6%. That should nearly correspond with the Fed rate range of 5.50%-5.75%, implying another 50 bps rate up from the current levels. A lot will now depend on how the other central banks like the ECB, BOJ and the Bank of England react.

Fed pause must be looked at in the right perspective. The Fed may have announced a pause in rate hikes, but has also hinted that rate hikes have another 50 bps to go. Clearly, the Fed is drawing a line between its short term strategy and long term policy. Fed is unlikely to turn away from its hawkish stance unless the inflation is surely moving towards 2%. But the good news for India Inc and for the RBI is that the rate pause has finally happened.

Why the Fed pause is a big relief to the RBI?

Without doubt, this is a relief for the RBI as its April stand gets ratified. It may be recollected that the RBI had announced a pause in rates in April 2023, at a time when the Fed was persistently hawkish. It was a risky gambit, but it appears to have worked well. The move by the RBI could have caused monetary divergence and resultant volatility and disruption in flows and the financial markets. Nothing of that sort happened and with the Fed also pausing, that looks unlikely to happen. Industry bodies may have impelled the RBI to go slow on rate hikes in April, but it seems to be a good decision in retrospect.

RBI is in a relatively more comfortable position compared to the Fed and here is the reason. For the RBI, the inflation target of 4% is now just about 25 bps away. On the other hand, the Fed is still 200 bps away from its inflation target of 2%. For now, the RBI can heave a sigh of relief as the Fed pause takes away any immediate risk of volatility in the financial and currency markets. RBI may have something to savour; more specifically because its brave gambit has paid off handsomely.