The Federal Reserve’s decision to pause its rate hikes in the September meeting was on expected lines. But despite the Chairman stating that there could be further rate hikes, if warranted, the rate hike cycle in the US appears to be ending. At 5.25 to 5.50 per cent, the Fed funds rate is quite close to the 5.6 per cent terminal rate projected by the Federal Reserve Board members for the end of 2023. With the Fed already having increased the policy rate by 525 basis points since March 2022, it is now likely to wait for the full impact of these rate hikes to work its way through the economy.
Besides rate hikes, the US central bank has also been draining liquidity from the system by reducing the treasury securities and agency debt and agency mortgage-backed securities held by it. The Fed balance sheet has shrunk around 9 per cent from the peak of $8.9 trillion in March 2022 to $8.09 trillion in September 2023. With the higher rates and tighter liquidity weighing on the housing sector and capital spending by businesses, the Fed is likely to be less aggressive in its rate action from here on.
Financial markets have however been unhappy about the Fed policy because they had been expecting rates to decline from the first quarter of 2024. But the summary of economic projections of Federal Reserve Board members shows that there could be just two rate cuts next year, compared to projection of four cuts of 25 basis points each, made in June. This indication of rates remaining elevated for longer has led to the dollar firming up and US bond yields moving higher after the meeting. Market participants however need to heed the Federal Reserve Chairman’s words that these projections are just expectations of Board members and are not cast in stone. The Fed appears to be managing market expectations so that financial markets do not get too exuberant. Of note is that the US economy seems to have achieved a soft landing, staving off recession for now. Real GDP in the US is now projected to grow 2.1 per cent in 2023 and 1.5 per cent in 2024, up from 1.0 per cent and 1.1 per cent projected for 2023 and 2024 in June this year. Unemployment is low and consumer spending is robust. These trends are encouraging for global growth and trade, and can reflect positively on India’s external trade.
Indian rupee and sovereign bond yields have not reacted much to the Fed policy on Thursday, though there was some selling in equity markets. Equity markets are right to be concerned since the Fed’s stance to hold rates at a higher level for a longer period is likely to impact the Reserve Bank of India (RBI), which will have to be mindful about the spread between the Indian and US sovereign bond yields. Sustained higher rates in India can drag corporate profits. With the high inflation mainly supply driven, the RBI will also do well to be on pause for now and take further action based on future data.