What to expect from the Fed policy in May?

Will the Fed hike rates on 03rd May?

As the Federal Open Markets Committee (FOMC) of the US Federal Reserve gets all set to announce its policy statement on 03rd May, the million dollar question is whether the Fed would again hike the rate of interest. For now, the Bloomberg consensus shows that the Fed would hike another 25 bps from the range of 4.75%-5.00% to 5.00%-5.25%. This would effectively translate into an aggregate rate hike of 500 basis points since the Fed started hiking rates in March 2022. However, we need to wait and see, but statements coming from the Fed appear to be crystal clear that they are not yet done with the rate hikes. However, with the recent collapse and bailout of First Republic Bank last week, it remains to be seen if the Fed holds on to its hawkish stance.

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Diverse pulls on Fed policy this time around

When the FOMC meets on the 02nd and 03rd of May, they will have a number of contradictory forces to play. On the one hand, there is consumer inflation that is still way above the 2% target of the US Fed. Secondly, there is the labour data which continues to be very strong and that is keeping consumer spending high. That is preventing a rapid fall in inflation. These two factors call for the Fed to continue its hawkish stance and raise rates further. On the other hand, there are two factors that also call for the Fed to go easy. Firstly, GDP growth in the first quarter of 2023 has fallen sharply to 1.1% as per the first advance estimates. That is sharply lower than the 2.6% growth evinced in the fourth quarter of 2022. Growth pressures are starting to show. The other factor is the banking crisis and the Fed may be inclined to hold rates to give some relief to the bond portfolios of smaller banks.

What does the CME Fedwatch indicator say?

The CME Fedwatch is more of a market-related indicator. It reflects implied probabilities of future rate hikes based on Fed futures trading on the CME futures exchange. Here, Fed futures prices are used to assess the quantum of rate hikes in each of the future FOMC meetings over the next one year. 

Data source: CME Fedwatch

How do we interpret this probability table of future rate hikes as culled from the CME Fedwatch? Here are the major takeaways.

1. The markets are almost certain that there would be a 25 basis points rate hike by the Fed in the May policy taking the upper range of rates to 5.25%. However, that is also the peak rate assumption, with only an outside possibility that the rates could go higher by another 25 bps to 5.50% during the next one year.
    
2. Compared to the last Fed minutes announced in mid-April, there appears to be less conviction in the markets about the willingness of the Fed to cut rates. While the market is still betting on rates trending lower in the next one year, the probabilities of lower rates are also much lower. This implies that the markets expect the Fed to sustain its hawkish policies for longer than was originally anticipated.
    
3. What are the broad rate expectations in the next one year between now and May 2024? On the upside, another 25 bps rate hike looks very likely in the May 2023 policy with only an outside possibility of another 25 bps rate hike in the next one year. That would happen only if inflation suddenly turns sticky. On the downside, the markets are betting on the rates trending lower by 75 to 100 basis points in the next one year. That is something even the Fed had indicated in its minutes. The market is now pegging just one rate cut of 25 bps in 2023 and the rest of the rate cuts in 2024.
    
4. What are the risks to this assumption? There are two broad risks; if the growth falls too sharply or if the banking crisis worsens. In that case, the Fed may even want to front-end the rate cuts in this year itself. For now, the banking crisis while being serious, does not looking anything close to the contagion of 2008. Hence, the Fed is unlikely to budge on its core policy direction.

Let us finally turn to some key takeaways for India.

India must monitor the risk of monetary divergence

In the April policy, RBI had opted to maintain the status quo on rates. Since early 2022, the RBI has hiked rates by 250 bps while the Fed has hiked rates by close to 500 bps. Post the rate hike in May 2023 (assuming the Fed hikes rates), the gap between Indian repo rates and the Fed rates would be just 125 bps, which is the lowest it has been in a long time. The one thing that the RBI must monitor is the risk of monetary divergence. In the past, such divergences have created huge volatility and that is something to be cautious about.