US Fed’s latest rate hike and its impact across markets

“My colleagues and I are strongly committed to bringing inflation back down to our 2% goal. We have both the tools we need and the resolve that it will take to restore price stability on behalf of American families and businesses,” a sombre US Federal Reserve chair Jerome Powell, under fire for a slow initial response to escalating inflationary buildup in the US economy, asserted Wednesday.

Following a two-day meeting in Washington of a key rate-setting panel, Powell also signalled a further intensification of the American central bank’s fight against runaway inflation in the coming months.

Powell continued with where he had left off at the Jackson Hole meeting on his stated resolve to tackle inflation.

Having sharply pivoted to make up for the initial slow response in tackling runaway prices that are hovering near the highest levels since the 1980s, the Fed Wednesday hiked its key interest rate by a substantial three-quarters of a point for a third straight time. More significantly, it hinted that further hikes were coming and that rates would stay elevated until 2024.

The impact

The Fed’s latest hike boosted its benchmark short-term rate, which acts as the peg for most consumer and business loans in the US, to a range of 3% to 3.25% – the highest level since before the 2008 financial crisis and up from near zero at the start of this year. Fed officials also signalled that, by early 2023, they expect to have further raised rates much higher than they had projected at the June review.

In a statement Wednesday following a two-day meeting in Washington, the Federal Open Market Committee – the Fed’s key rate-setting panel – reiterated that it “is highly attentive to inflation risks”. The central bank panel also asserted that it “anticipates that ongoing increases in the target range will be appropriate,” and that it “is strongly committed to returning inflation to its 2% objective”, something that Powell echoed multiple times as well in his briefing and the subsequent press conference Wednesday.

Policy conundrum

The Fed’s action followed a US government report earlier in September that showed high inflation spreading more broadly through the economy, with price surges for house rents and other services increasing even though petrol prices had eased, according to a Wall Street Journal report. Inflation had peaked at 9.1% in June, as measured by the year-on-year US consumer price index. Two months later, in August, it was still ruling at 8.3%.

For mounting an effective response though, the problem for policy mandarins is the continuing buoyancy in the US job market, which has remained resilient and with the unemployment rate, at 3.7%, still way below levels most analysts consider to be sustainable in the longer run. The failure of the labour market to soften has added to the impetus for a more-aggressive tightening path at the US central bank. So, by hiking borrowing rates, while the Fed makes it even costlier to take out a home loan or a vehicle or business loan and as a result, consumers and businesses are expected to cut down on spending, a strong wage growth effectively negates this objective.

With the US Federal Reserve set to hike rates further, outflows from emerging markets are likely to continue, putting pressure on the currencies and markets in countries such as India. Benchmark indices in India were down in opening trade on Thursday while the Rupee is likely to fall further after hitting a record low to the US dollar Thursday. The rupee opened at a record low of 80.2850 per US dollar today, down from 79.9750 in the previous session, according to Reuters data. Other Asian currencies too opened weaker, with the Chinese yuan slipping below 7.10 to the dollar.

Fed signals

Traders across markets have been looking for signs since early this year that the Fed might be more aggressive about rolling back the stimulus that has been feeding stock market gains across geographies. The new projections in response to the inflation trajectory 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.

The Fed’s inflation-busting action comes amid criticism that the US central bank has fallen behind the curve on inflation. 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 and stayed consistently high, partly due to external factors, including the war in Ukraine and the continuing Covid-19 shutdowns in China’s key manufacturing hubs.

Impact across markets

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.

The Fed is not alone in its intention to hike rates. The Bank of England has announced multiple rate hikes since December, pushing its benchmark rate well over 1 per cent for the first time since 2009. Australia, Brazil and Canada too have also raised rates, while the European Central Bank has also followed suit with a 0.75 percentage point hike.

In India, the Reserve Bank of India (RBI) could raise interest rates by 50 basis points (one basis point is one-hundredth of a percentage point) at its upcoming policy review later this month. Upasana Chachra, the chief India economist at Morgan Stanley, said in a note Friday that the investment firm had earlier expected a 0.35 percentage point hike but “sticky inflation and continued hawkish stance of developed market central banks warrant continued front-loading of rate hikes in our view.”

Rate cycles

Interest rate hikes are the primary monetary policy tool used by central banks to tackle sporadic spurts in inflation. 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 invest in new projects.

A subsequent 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 emerging market economies, especially from a debt market perspective. Emerging economies 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.

EME outflows

A sharper-than-expected 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 and a lockdown-induced downturn.
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.

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