Fed’s lift-off guidance shallow, trajectory may need to be recalibrated

FOMC’s announcement of a quicker taper and rate lift-off captures the US Fed’s eagerness to make good its earlier falling behind the curve. The taper has now been doubled to $30 billion per month, implying an end to quantitative easing (QE) by Mar’21. Although the timeline for lift-off has not been decided yet, Fed Chair Jerome Powell indicated that it would start soon after the end of QE. Moreover, the FOMC has not revealed its balance sheet shrinking plans.

This shift in stance by the Fed from its earlier complacency is rooted in the change in its description of inflation from transitory to persistent and widespread. The spurt in core inflation to nearly 5% (core CPI) along with rapid wage growth (10% YoY in Oct’21) is creating a risk of inflation getting entrenched, according to the FOMC statement.

The other change in stance is that the Fed now thinks that the decline in labour participation rate (LPR at 61.8%) is unlikely to regain the pre-COVID level of 63.4% any time soon, thus implying an enduring backward shift in labour supply, translating into high wage and price inflation.

Powell was also emphatic that the ultra-loose monetary policy was no longer required as the labor market has been unexpectedly very tight and the economy has been on a fairly strong footing.

These changes are reflected in the FOMC’s economic projections summary.

After registering 5.5% in 2021, real GDP growth will decelerate to 4% next year, which will still be very strong compared to the potential long-term growth of 1.8%. The potential impact of the Omicron wave has also been downplayed as the Fed thinks that the economy is fairly strong to withstand it, as is the case with the delta variant that is currently spreading in the US.

Likewise, considering the much faster decline in unemployment rate (4.2% in Nov’21), it is forecast to drop to 3.5% in 2022 (vs. earlier projection of 3.8%), implying a speedy fall to 50-year lows.

While inflation projections till 2023 have been scaled up (4.4% for 2021) it remains higher than 2% even till the end of 2024 (2.15%).

The overall read-through of the economic projections imply that the Fed’s objectives of inflation somewhat above 2% for some time and maximum employment will be satisfied in an enduring manner.

Based on the dot plots, FOMC members now see three rate hikes of 25bp each in 2022 vs. only two in the earlier projection. This is followed by three more hikes in 2023.

In our view, today’s announcement still represents a shallow rise in rates as the real fed fund rate will continue to remain negative at -0.7% (Fed rate minus core PCE inflation projection) even by the end of 2023. And it does not turn positive by the end of 2024. Thus, after the next three years the real rate is projected to remain lower than the Fed’s long-term real rate estimate of 0.5%.

This is inconsistent with higher than 2% inflation during the entire projection period along with a very strong economy and historically low unemployment rate. A look at the pre-COVID projection table of Dec 2019 shows that even with a slower growth trajectory and lower inflation, the real Fed rate was projected to turn positive (0.1%) by the end of 2022.

Sustenance of negative real rate for another two years will hardly dampen the elevated inflation, which is now seen as persistent, running a risk of getting entrenched and potentially triggering a wage-price spiral. Thus, the guidance for shallow rate normalisation will need to be further calibrated to a higher trajectory over the next two years. A condition that could indicate such a possibility is sustained rise in wages above labour productivity growth.

The shallow lift-off trajectory will ensure that the financial markets do not immediately react adversely to the normalisation. But what is imminent now is that the Fed’s assurance of persistent accommodative support for the financial market, reflected in suppression of market risk premium – credit and illiquidity – will get diluted. This would imply higher market volatility, going forward. Also, a quicker taper and rate lift-off can induce other central banks such as ECB and BoE who are also facing high inflation to start their normalisation process.

Emerging markets such as India will thus see tightening of financial conditions. Inflation is also seen rising in India (core CPI seen at 6.5-7% in the next 12 months) due to recovery in consumption demand, and the backlog of higher cost inflation, thereby leading to initiation of rate hikes by the RBI. Stronger dollar on the back of Fed’s normalisation will lead to continued weakening of INR/USD and a decline in excess liquidity in the banking sector, in our view. Our JM portfolio is aligned with these inflection points with overweight on IT and pharma. We believe export-oriented sectors can outperform. We also reiterate that a strong dollar view will impact valuations for financial services and metals sectors, where we are underweight.