The Federal Open Market Committee’s December meeting was among the most disruptive in recent times with the US equity markets crashing and the dollar index and US treasury yields spiking sharply. Other markets too witnessed similar volatility. To be sure, the 25-basis points reduction in the Federal Funds rate and the reduction in the Fed’s holding of treasury and other securities were on expected lines.

But financial markets were taken aback by the Fed Chairman’s hawkish commentary. Jerome Powell said that the 100-basis points rate cut in the current easing cycle (since September this year) might have run its course. He remarked that “from here it is a new phase and we are going to be cautious about further cuts”, expressing disappointment over inflation moving “sideways”. This hawkishness was reinforced by the projections made by the Federal Reserve Board members. They forecasted only two more 25-basis points rate cut in 2025, down from four cuts of 25-basis points projected in September. The signal is unmistakable — that future interest rate cuts will be few and dependent on incoming data and evolving outlook on inflation, jobs and growth. Financial markets are unhappy that interest rates are expected to remain elevated until 2026. The Fed also indicated the end of the ultra-low-interest rate regime, in place since the global financial crisis in 2008 — with the terminal rate over the long-term being projected at 3 per cent. Investors in equity, commodity, cryptos and other assets will have to reduce their positions to adjust for the higher cost of financing. This may cause further volatility in financial markets.

The Fed, however, appears justified in slowing down its rate-cut cycle, as growth in the US remains healthy and the jobs market is cooling down. Inflation, on the other hand, is likely to prove a challenge in the months ahead. While PCE (personal consumption expenditure) inflation is well below the 7.2 per cent recorded in June 2022, it is yet to move below the Fed’s long-term target of 2 per cent. PCE prices grew 2.5 per cent in November and core PCE was up 2.8 per cent. Besides, the Fed would surely be cognizant of the risks posed to inflation by the impending increase in import tariffs, once the regime changes in January 2025.

The inflation threat is, however, not limited to the US alone. Once Trump begins increasing tariffs after assuming office, other countries, including India, may have to take retaliatory measures, increasing the odds of higher levels of inflation in all countries. The prospect of sharp depreciation in all emerging market currencies against the dollar will add to the imported inflation. While the rupee’s depreciation against the dollar in 2024 has been far lower compared with currencies of other emerging economies, the RBI has also been using up forex reserves to prevent volatility. The RBI Monetary Policy Committee has truly missed the chance to cut rates this month. As global headwinds loom in the New Year, it would have to contend with new complications.

Published on December 19, 2024