Fed’s steep rate normalisation path will push RBI also into action

The new trajectory of monetary normalisation guides the Fed’s fund rate rising to 1.9% by the end of 2022 following the initial 25-basis point (bps) rate hike. This implies front-loading more than what was expected till the end of 2023 — at 1.6% — in the Dec’21 meeting. The Fed plans to follow it up with further rate hikes of 100 bps in 2023.

The Fed chair also indicated that balance sheet tapering will start from May’21 and that trajectory would have a similar framework as we saw during 2017-19. But it will be much faster. We read this to mean a monthly rundown of $50 billion compared with $29 billion in the last cycle. This will be quicker than our expectation of $15-30 billion per month.

The summary of economic projections shows dramatic changes. It contains a markedly higher inflation trajectory and significantly lower growth projections.

Real GDP growth projection for 2022 has been scaled down to 2.8% from 4.0%, while the projections for the following years remain unchanged, converging to 2% by 2024. This would be a considerable deceleration from 5.8% in 2021.

The headline PCE inflation projection has been scaled up by a huge 170 bps to 4.3% by year-end 2022. It will likely remain higher than the Fed’s target of 2% even over the medium term — 2.6% in 2023 and 2.3% by the end of 2024. Core inflation is also seen higher by 140 bps than the last projection at 4.1% by the end of 2022 compared with the current 6.4%. It also remains elevated till the end of 2024 at 2.3% (2.1% in the last projection).

Despite the major scaling down of growth projections and stepped up inflation forecasts, the Fed considers the economic conditions to be very strong, labour market robust and aggregate demand vigorous. High inflation is, thus, seen sustaining longer as the supply chain constraints are expected to linger and worsen due to the Russia-Ukraine crisis.

Fed’s aggressive normalisation is unequivocally geared towards tempering the demand side, which will result in slower growth. As we have held earlier, steps to tame inflation will temper the robust near-term demand but it will be necessary to shore up forward-looking indicators, which have plummeted sharply — a combination that we fear mimics the 1972 situation, ahead of the 1973-75 US recession.

The tiny 25 bps hike implemented today is aimed at ensuring that the Fed’s immediate actions do not add to the uncertainty emanating from the ongoing Russian-Ukraine war. But it is certain that the pipeline of aggressive normalisation is aimed at tightening financial conditions, which is a quintessential channel through which the normalisation will affect the economy, particularly inflation.

Accordingly, the trajectory of decline in US money supply/GDP ratio from the current 90% to 80% will be achieved by the end of 2023, sooner than our projection of it happening in 2024.

Also, with the Fed rate rising to 2.8% by the end of 2023 and core inflation declining to 2.6%, the implied real rate is projected at 0.20%, still a little less than the generally accepted neutral rate for the US at 0.5%. This will be a very steep rise from the current real rate of -6.3%, which is an 80-year low. A 700 bps rise in the real rate would increase the probability of US recession significantly. But the Fed hopes that a recession will be avoided with growth projected to ease to 2.2% in 2022, higher than the potential 1.8%. Given the slim window the Fed now has to dial down from the historically high inflation quickly, the margin of error for Fed’s gambit is exceedingly narrow.

Our oft-repeated view has been that the speedy and clustered normalisation of US monetary policy through rate hikes and balance sheet squeeze will impact markets in multiple ways. It will result in further FII retrenchment from EMs (India has already seen an outflow of $17 billion YTD in FY22); compress equity market valuation, working separately through a rise in the real rate and decline in global excess liquidity; lead to a stronger dollar and rising US Treasuries’ rate should weaken INR/USD and harden Indian yields. With almost 200 bps rate hike by the US Fed, and higher inflation surprises in India, we maintain that the Reserve Bank of India (RBI) will also be forced to implement 100-110 bps hike in policy rates.

Our portfolio positioning has been defensive with lower weight on deep cyclicals such as banks, BFSI, metals (steel), rate sensitives like capital goods, and broader industrials. We have also been cautious on midcaps and smallcaps. We have been more constructive on urban consumption, IT, pharma, autos, and select staples.