FED hikes rates by 25 bps but this may be the end

FED hikes rates by 25 basis points

There was not much of a surprise element in the Fed hiking rates in the July 26, 2023 meeting. As expected, the Fed hiked the rates by 25 bps, taking the rates to the level of 5.25% to 5.50%. That is a full 525 basis points from the level of March 2022 when the rate hikes started off for the first time. However, the July rate hike was never in question. The big question was whether this would be the last rate hike or will there be one more rate hike by the Fed as indicated by Jerome Powell, the Fed chair? While the Fed has been non-committal in the meeting, its statement has been interpreted in a fairly interesting way. Fed had stated that they could opt for a longer pause, and that has been interpreted by the market as a signal that the Fed may be done and dusted with its rate hike program. What really supported the view was the flow from two sets of data this week.

Q2 GDP in the US comes in higher at 2.4%

In the US Q2 refers to the period to June, since the US follows the calendar year cycle. After growing at 2% in the first quarter ended March 2023, the first advance estimate of GDP growth in Q2 has come in higher at 2.4%. This is not just higher than the sequential quarter but also higher than the street consensus estimates of 1.8% to 2.0% GDP growth in the second quarter. The spike in the real growth was, however, led by falling inflation, which is a good sign. However, the nominal GDP growth has actually fallen sharply in the June quarter. The Fed would be happy with the fact that the higher real GDP growth in the June quarter has been driven by lower inflation, rather than nominal growth. However, the Fed would not want to get into a situation wherein the nominal growth comes under pressure. That makes a strong case for the Fed to pause now, although the pause could be long.

PCE inflation came in sharply lower at 3%

On July 28, 2023 the US Bureau of Economic Analysis also announced the personal consumption expenditure (PCE) based inflation. The PCE inflation is relevant as it is a barometer of consumption spending and also of inflation. It is the PCE inflation, and not the consumer inflation, that the Fed uses for its rate decisions. For the month of June 2023, the PCE inflation came in sharply lower at 3% at a headline level while the core PCE inflation also fell by 50 bps to 4.1%. It is the core PCE inflation that the Fed has been trying hard to bring down. The Fed target is to first bring down the headline PCE inflation to 2% and then bring the core PCE inflation down to 2%. Now, both these appear to be on track, which is another factor that could spur the Fed to go slow and call a halt on rate hikes for now. That is what the CME Fedwatch is also indicating after these data flows came in.

But, what exactly did the FED say in its statement?

While the GDP data and the PCE inflation date are fairly emphatic about falling inflation and the chances of a rate pause after July, even the Fed statement broadly appears to hint at that possibility. Of course, the Fed statement was still ambiguous on the likelihood of future rates, but that is more because the Fed always wants to keep one escape window open. Here are some of the key takeaways form the Fed statement.

1. Jerome Powell has hinted that they would prefer to take a call on rates meeting by meeting and is absolutely loath to  committing on future trajectory of rates. One hint was that during the post-policy conference, Powell spoke more about rate cuts next year than about rate hikes this year. That could be interpreted as a hint that the Fed may be done and dusted with its rate hikes in this round.
    
2. One of the very important statements made by Powell was that inflation is coming under control. The Fed cannot ignore the fact that rates are at a 22-year high and the cost of funds has been making life tough for US corporates. Fed cannot afford to take too much of a risk at this point. In fact, economists are calling this a “Hawkish Hold.”
    
3. The message from the Fed appears to be that, going ahead, the Fed may play more with the length of pause than with the rate hikes. Instead of pausing for couple of months, the Fed may choose to pause for longer and that may be used as an alternative to rate hikes. After all, tighter bank credit and the tapering of the bond book of the Fed has also contributed meaningfully to the tightness in the market. 
    
4. The big shift in the policy statement was on outlook for GDP growth. The Fed statement upgraded the outlook for GDP growth from Modest to Moderate, an indication that chances of a recession were receding. With robust GDP having saved the day for the Fed, the central bank may now want a genuine soft landing. 

For India, this is good news as it would put less pressure on the RBI to hike rates to avoid monetary divergence. That may not be necessary now. The taper could tighten passive flows into India, but that is not really showing up. What India would relish is the statement by Powell, “It is possible that Fed would choose to hold steady and as we make careful assessments, meeting by meeting.” That is as close to a less hawkish statement as the Indian central bank can hope for. That is; assuming that macros do not worsen in the US.