The Rate Hike Cycle of the U.S. Fed
Context: The U.S. Federal Reserve (Fed) last week paused its rate hike cycle by deciding to hold interest rates after ten rate hikes since March 2022. What does a pause in rate hikes mean?
- A pause by the Fed increases the chances that the economy could slow gradually – towards a soft landing — rather than descending sharply into recession.
- Three-pronged impact of a pause:
- Attractive currency carry trade: If the Fed pauses its policy rates and subsequently moves to cut rates, the differential between the interest rates of the US and a second country would either remain steady or widen, thus making the other country more attractive for the currency carry trade (leveraging the interest rate arbitrage).
- Growth in the US and world: A pause by the Fed would also mean a higher impetus to growth in the US, the world’s biggest economy, which could be positive news for global growth.
- Lower returns in the US debt markets:
- It could also trigger a churn in emerging market equities (EMEs), increasing foreign investor enthusiasm.
- There is also a potential impact on currency markets in EMEs, stemming from possible inflows of funds.
- Central Bank’s Wait for Decisive Inflation Slowdown: The central bank is waiting for signs that there has been a decisive slowdown in inflation before it decides on further actions.
- Inflation Still Higher Than Fed’s Target: Though inflation has dropped from 9% during the pandemic, it is still higher than the Fed’s stated target of keeping inflation within 2%.
- Labor Market Resilient to Rate Hikes: The labour market does not seem to be heavily affected by the Fed’s rate hikes since last year.
- Caution in Allowing Interest Rates to Rise: The effects of monetary policy usually take time to impact prices in the wider economy. So, the Fed is cautious after a series of ten rate hikes about allowing interest rates to rise too much and too soon.
- Risk of Undershooting Fed’s Inflation Target: A rapid withdrawal of monetary support can cause prices to undershoot the Fed’s inflation target.
- Economists said that this will not affect India’s interest rate decision and that it is unlikely that the RBI will precede the US Fed in pivoting to a rate cut.
- In India, the Bond yields shall consolidate from here on with a downward bias.
- The amount of systemic Liquidity shall influence the movement of yields in the short term.
- The impact on Indian markets will be neutral in the short term and the Indian markets will take further cues from the slowdown in the US economy and inflation which will result in rate cuts in the latter part of the year.