US Fed to carry out more rate hikes, RBI may need to follow suit

The US Fed followed its first 25 bps rate lift-off in April 2022 with a double barrel action of another 50bp hike and a planned balance sheet squeeze starting from 1st May 2022. The Fed’s bigger-than-normal hike of 50bp takes the target Fed rate to 75 bp and will be followed by rate hikes of a similar magnitude in the coming meetings. The balance sheet rundown will start with a USD 47.5 billion monthly reduction (including treasuries, and ABS) for three months, followed by a larger monthly rundown of USD 95 billion.

Thus, the FOMC has committed to increasing the pace of normalisation. However, the fact that the Fed has refrained from making an aggressive move (of 75bp hike) more that than already known (50 bp) reflects a calibrated normalisation path to deliver a soft landing of the economy. Fed chair Jerome Powell was also emphatic that there is good chance that a US recession or even a significant slowdown arising from the ongoing monetary tightening can be avoided as the US economy is very strong, the labour market is extremely robust, and the Fed’s balance sheet is in good shape.

The Fed attributes high inflation to two critical elements a) a very tight labour market, and b) accentuating supply constraints due to the on-going Ukraine-Russia war and the fresh pandemic-led lockdown in China. The task of price stability and containing inflation expectations (1-year forward at 5.4 per cent, 5-year at 3 per cent as per survey data) arising from the former is complicated by exogenous events, which have accentuated the synchronous rise in global commodity prices. As of now, the combined effect of these two factors has taken headline inflation to a 40-year high of 8.5 per cent, core CPI to 6.5 per cent (March 2022) and the much-tracked core PCE to 5.2 per cent (February 2022), way higher than the target of 2 per cent. In addition, the house prices inflation base on Case Shiller indices is hovering in the vicinity of 20 per cent YoY, reflecting a house price bubble.

The severe imbalances in the labour market need slowdown on the demand side, which is necessitating both monetary tightening and removal of fiscal support, which has been reiterated by President Joe Biden this week.

The labour market tightening reflects in strong wage growth with hourly earnings growth of 5.6 per cent YoY despite the recent rise in labour force participation rate to 62.4 per cent (March 2022) from 61.7 per cent in September 2021, and little lower than the pre-Covid level of 63.5 per cent. The gap between job vacancies at 10.8 million and people unemployed at 5.9 million is perhaps the largest ever and the vacancies/unemployed ratio at 1.8x is significantly higher than 0.86x a year back.

The Fed hopes that its tightening measures along with the fiscal drag will help slow the economy enough to curtail labour demand and vacancies to match with the number of unemployed, thereby breaking the potential scenario of wage-price spiral. It also expects that the intended lowering of vacancies/unemployed ratio will not lead to an increase in the unemployment rate, which at 3.6 per cent is currently close to historical lows.

Overall, the Fed chair’s conviction on a soft landing, avoiding a recession and managing price stability has calmed the market anxiety, but it also implies continued tightening and balance-sheet shrinkage, which will work through deflating asset prices. The outcomes on inflation will be measured against the expected flattening of core inflation and eventual attainment of the 4.1 per cent target by year-end 2022 and 2.6 per cent and 2.3 per cent in the following two years. That will determine whether the current tightening path will need to be scaled up or not. It essentially implies that at this juncture the Fed does not want to over-react as it still hopes that there are considerable transient elements in the current 40-year high inflation. The past track record has shown that such hopes are misplaced. The risk is that there can be steeper rate hikes beyond the 2 per cent projected for year end 2022 and 2.8 per cent by 2023.

From the Indian perspective, RBI has already initiated its first repo rate hike of 40 bp to 4.4 per cent and 50 bp CRR hike in alignment with the US Fed’s tightening path and in the light of significant upside risk on inflation. Given the tightening trajectory outlined by the US Fed and inflation concerns, India too will need to sustain its tightening.