Fed tones down rate hikes to 50 bps

After hiking the Fed rates by 75 bps for 4 FOMC meetings in succession, the US Federal Reserve restricted itself to just 50 bps rate hike in the latest December 2022 meeting of the Federal Open Markets Committee. The million dollar question is; what do we read from the latest Fed statement and what are the implications for Indian markets as well as for the RBI monetary stance.

Fed tones down rate hike intensity

That is actually the right word. Fed is still hawkish but has toned down its intensity. After hiking rates for 75 bps in 4 consecutive Fed meetings, in December, the Fed toned it down to 50 bps. That takes the rates to the range of 4.25% to 4.50%. The Fed has hiked by a full 425 basis points since March this year when the Fed shifted its stance from neutral to hawkish.

What is the fed saying now? One thing is that the Fed is not done with rate hikes yet. What we gather from the Fed statement is that there could be another 75 basis points of rate hike happening in 2023. This would be mostly likely spread across 3 tranches of 25 basis points each, which means the intensity of hawkishness will reduce still further.

Fed rate target clarity now emerges around 5.1%

Now there is a lot more clarity on the terminal Fed rates, or where the rate hikes would eventually come to an end. The indicated targets used to be 4.6% till the previous meet, but now the Fed has decisively stated that its terminal rate target would be around 5.1%. That would correspond with an interest rate range of 5.00% to 5.25% and the Fed wants to achieve this target rate of interest by May 2023.

Why has the Fed toned down hawkishness but raised the terminal rates of interest? Toning down of hawkishness was inevitable since the rates have already gone up 425 basis points in this year and are at a 15 year high. The terminal rates have been raised because the Fed does not want to either bring down rates or even stop rate hikes till the inflation shows signs of decisively moving towards 2% target.

CME Fedwatch – what is it indicating?

A very meaningful way of projecting rates in the coming year is through the CME Fedwatch which estimates probabilities of rates based on the Fed futures trading data. In short these are implied probabilities based on traded prices so they reflect market reality. Here is where rates look to converge in the coming few months of 2023.
 

To cut a long story short, there is a strong probability that the Fed rates could touch the peak range of 5.00% to 5.25% by May 2023. That implies 3 rate hikes of 25 bps each in the next 3 meetings.
 

Can rates go down in 2023?

If you go by the CME Fedwatch, rate cuts are possible, although that could be contingent upon the inflation falling rapidly towards the 2% target. Alternatively, rates could be cut if the impact on growth is significant i.e. high rates start genuinely hitting consumption and growth. The CME Fedwatch estimates that by September 2023, there could be a strong probability that the Fed may be inclined to reduce rates partially. This could be either due to growth impact or due to inflation falling or a combination of both.  

Here is the most likely scenario in 2023. The Fed could implement 3 rate hikes of 25 bps each in February, March and May 2023. That would be a case of front loading rate hikes in 2023 too and allowing peak rates around May 2023. To an extent, the confidence of the Fed and the Fedwatch stems from the fact that consumer inflation in the US has fallen to 7.1%.

Fine print of the Fed statement

It is said that in any statement by a central, the most cryptic messages are to be read between the lines. Here are 3 cryptic messages that emerge.
 

• Fed believes that with rates well above the neutral rates at 2.5%, it would be more than sufficient to push the inflation down rapidly. Fed is also betting that the cumulative impact of all the hawkishness should be palpable in coming months.
• Powell has warned of any undue haste in changing the hawkish stance as history is against any premature loosening of policy. That means; Fed would reverse its stance only if it is convinced that inflation was decisively moving towards 2% levels.
• One issue has been hard landing and the risk of a recession. These fears are already rampant in the US UK and EU. Post the positive GDP growth in the US economy in Q3, the Fed chair is substantially more confident that Fed can manage to avoid a hard landing. That is likely to drive rate action in 2023.

How should Indian markets read the Fed statement

There are 3 things that should gratify markets from the Fed statement. Firstly, the Fed is reducing its intensity of hawkishness. Secondly, the terminal rates are not too far from here and the Fed has given clarity. That helps RBI to plan its rate action. Lastly, risk-off outflows are very unlikely now with India having positive real rates of yields on 10 year benchmark bonds compared to the US offering negative real returns on 10 year benchmark bonds. 

Time for RBI to focus on growth?

That is the bottom line. The goals and priorities of the US economy and the Indian economy are at divergence with one another. Sample these. For India, growth is its biggest leverage and the RBI has to revert back to boosting growth. That means, lower rates, lower cost of funds and ample liquidity. RBI should take solace from the latest CPI and WPI inflation numbers in India, which serve to underline that inflation is coming down. RBI was quick to turn hawkish in sync with the Fed and now it must be quick to diverge from the Fed. It is a challenge, but for the RBI it must be growth above all else.