Do it yourself: FOMC

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Thursday, August 28, 2025

Refinement of the monetary policy framework in India

The Reserve Bank of India adopted its current monetary policy framework in August 2016, under the governorship of Dr. Raghuram Rajan. This marked a major shift in the monetary policy formulation process in India.

In the pre-independence era, the function of monetary policy was mainly to maintain the sterling parity, with the exchange rate being the nominal anchor of monetary policy. Liquidity was regulated through open market operations (OMOs), bank rate and cash reserve ratio (CRR). After independence, India adopted the planning model of development, loosely based on the USSR model. The role of RBI monetary policy in this model was mostly to regulate credit availability, employing OMOs, set bank rate and reserve requirement in congruence with the planning objectives and development needs of the country.

The monetary policy framework witnessed a major shift between from mid 1980s to late 1990s. In 1985, on the recommendation of the (Dr. Sukhamoy) Chakravarty Committee, a new monetary policy framework was implemented. This framework was primarily based on targeting with feedback models. This framework was termed “Monetary Targeting with Feedback” as it was flexible enough to accommodate changes in output growth. The RBI was mandated to control inflation within acceptable levels with desired output growth. Further, instead of following a fixed target for money supply growth, a range was followed which was subject to mid-year adjustments.

Developments like deregulation of interest rates, integration of the Indian economy with the global economy, liberalization of the exchange rate system, etc. in the mid 1990s, warranted a change in the monetary policy approach. The RBI began to deemphasize the role of monetary aggregates and implemented a multiple indicator approach (MIA) to monetary policy in 1998 encompassing all economic and financial variables that influence the major objectives outlined in the Preamble of the RBI Act. This was done in two phases—initially MIA and later augmented MIA (AMIA) which included forward looking variables and time series models.

The current monetary policy framework of the RBI was adopted in 2016. This framework was based on the recommendations of the (Dr. Urjit) Patel Committee report. The Committee recommended a monetary policy framework that was largely based on the US FOMC model – flexible inflation targeting by RBI and a six-member statutory Monetary Policy Committee (MPC) for setting the policy repo rate. The key tools of monetary policy implementation under this framework have been the repo rate as the primary policy rate, supported by liquidity management tools like open market operations, standing deposit facility, and marginal standing facility.

The Monetary Policy Framework Agreement (MPFA) was signed between the Government of India and the RBI in February 2015 to formally adopt the flexible inflation targeting (FIT) framework. This was followed up with the amendment to the RBI Act, 1934 in May 2016 to provide a statutory basis for the implementation of the FIT framework. The Central Government notified in the Official Gazette dated August 5, 2016, that the Consumer Price Index (CPI) inflation target would be 4% with ± 2% tolerance band for the period from August 5, 2016 to March 31, 2021. The same tolerance band has however continued even after the March 2021 deadline.

The framework has, so far, helped anchor inflation expectations, reduce inflation volatility (from 7.5% pre-2016 to ~5% post-2016), and support growth, though challenges remain due to supply-side shocks (e.g., food and fuel prices) and external spillovers.

The RBI has now released a discussion paper listing proposals to suitably refine the extant monetary policy framework, to address emerging economic challenges, such as supply shocks, global uncertainties, and climate-related risks. The goal is to maintain price stability while supporting economic growth and financial stability in a dynamic global and domestic environment.

Proposed refinements

Inflation target and tolerance band: Retain the 4% CPI inflation target but review the ±2% tolerance band. RBI proposes (i) narrow the band (e.g., ±1.5%) for stricter inflation control; or (ii) maintain the current band but clarify its use to avoid misinterpretation as a range for persistent deviation; or (iii) Introduce asymmetric bands (e.g., tighter upper bound to prioritize high inflation control). RBI also suggests considering core inflation (excluding volatile food and fuel prices) as a secondary guide to better reflect demand-driven pressures. Public comments are invited by September 30, 2025, on key questions: Should the 4% target or ±2% band be revised?

Scope of inflation targeting: Continue using headline CPI as the primary metric due to its broad coverage and public relevance. Explore supplementary indicators (e.g., core inflation, inflation expectations, or sectoral indices) to address supply shocks like food price spikes, which are less responsive to monetary policy.

Monetary policy committee (MPC) processes: Enhance transparency through more detailed MPC minutes and forward guidance on policy intentions. Propose increasing the frequency of MPC meetings (e.g., monthly instead of bimonthly) to respond more swiftly to economic developments. Consider expanding external member expertise to include climate economics and global trade specialists.

Incorporating new challenges: RBI proposes to incorporate certain contemporary challenges in the process of setting monetary policy. These new challenges include - (i) Climate Risks: Integrate climate-related risks (e.g., weather-induced food price shocks) into the framework, potentially through adjusted forecasting models or stress-testing scenarios. (ii) Digitalization and Fintech: Account for the impact of digital currencies and fintech on money supply and monetary transmission. (iii) Global Spillovers: Strengthen coordination with global central banks to mitigate the impact of external shocks (e.g., U.S. Federal Reserve rate hikes, commodity price volatility).

Monetary policy transmission: Address lags and inefficiencies in policy transmission (e.g., slow pass-through of rate changes to lending rates) by improving banking sector competition and liquidity management. The RBI proposed exploring alternative tools, such as forward guidance or yield curve control, to enhance transmission in volatile markets.

Growth and financial stability: Balance inflation control with growth objectives, especially in the context of India’s post-pandemic recovery and structural reforms. Strengthen coordination between monetary and fiscal policies to avoid conflicting signals (e.g., high fiscal deficits undermining inflation control).

Rationale for Review

Changing economic landscape: Rising supply-side shocks (e.g., food and energy prices, climate disruptions) and global uncertainties (e.g., geopolitical tensions, monetary tightening in advanced economies) require a more adaptive framework.

Inflation dynamics: Persistent food inflation and volatile global commodity prices challenge the FIT framework’s effectiveness.

Stakeholder feedback: Public and expert consultations highlight the need for greater clarity on the tolerance band and flexibility in addressing non-monetary inflation drivers.

Expected Impact

Price Stability: A refined framework could better anchor inflation expectations, reducing volatility.

Economic Growth: Enhanced flexibility may support growth without compromising inflation control.

Resilience: Addressing climate and global risks could make the framework more robust to shocks.

Challenges: Narrowing the tolerance band or increasing meeting frequency may strain RBI resources and require careful calibration to avoid over-tightening.

Tuesday, August 26, 2025

Chairman Powell stopped just short of committing a cut

Federal Reserve Chair Jerome Powell delivered his final keynote address at the Jackson Hole Economic Symposium on August 22, 2025, hosted by the Federal Reserve Bank of Kansas City. The speech focused on the U.S. economic outlook and the Federal Reserve’s monetary policy framework review, addressing the Fed’s dual mandate of price stability and maximum employment.

In his speech, Powell noted the U.S. economy’s resilience despite challenges from President Donald Trump’s tariffs and immigration policies. Inflation remains above the Fed’s 2% target (PCE index at 2.6% in June 2025), driven partly by tariff-related price increases, while the labor market shows signs of weakening, with July’s job growth at 73,000, well below expectations, and downward revisions of 258,000 jobs for May and June.

Monetary Policy Outlook: Powell signaled openness to interest rate cuts at the September 16-17, 2025, FOMC meeting, admitting that monetary policy is in restrictive territory, and the baseline outlook and the shifting balance of risks may warrant adjusting the policy stance. However, he avoided committing to a specific timeline or size of cuts, citing mixed signals from rising inflation and a cooling job market.

The CME FedWatch tool showed a 74% probability of a September rate cut, down from near certainty earlier in August, reflecting uncertainty about the size and timing.

Powell also spoke about Fed’s revised “Statement on Longer-Run Goals and Monetary Policy Strategy”, emphasizing adjustments to address evolving economic conditions, such as demographic shifts and productivity changes affecting labor markets.

Political Pressures: While Powell did not directly address political pressures, the speech occurred amid President Trump’s criticisms of the Fed’s independence, including calls for Fed Governor Lisa Cook’s resignation and Powell’s own potential replacement, as his term ends in May 2026.

How experts read Powell lips

Market experts, participants, and media provided varied interpretations of Powell’s speech, reflecting its cautious tone and the complex economic environment:

Analysts at Barclays and BNP Paribas revised their forecasts to predict a September rate cut, interpreting Powell’s remarks as dovish, though he avoided endorsing large cuts (e.g., 50 basis points) sought by some Republicans.

Experts highlighted Powell’s acknowledgment of a “challenging dichotomy” between tariff-driven inflation and a weakening labor market. Deutsche Bank analysts noted that a hawkish stance could unsettle markets, particularly for rate-sensitive sectors like homebuilders and small caps. Conversely, a dovish tilt was seen as supportive of equities.

Media outlets, including The Guardian and Reuters, emphasized the political backdrop, with Trump’s attacks on Fed independence overshadowing the speech. Trump’s comment, “He should have cut them a year ago. He’s too late,” underscored tensions, with some analysts concerned about the Fed’s autonomy.

Overall, experts and media saw Powell’s speech as a balancing act, addressing economic challenges while navigating political pressures and maintaining Fed credibility. The lack of a clear commitment to rate cuts left room for interpretation, with some viewing it as pragmatic and others as overly cautious.

Global Perspective

The presence of other central bankers, such as ECB President Christine Lagarde and Bank of England Governor Andrew Bailey, at the symposium, highlighted global monetary policy coordination challenges. Media noted the symposium’s focus on labor market transitions and data quality issues, with declining survey participation affecting economic projections.

Market Reaction

Financial markets responded positively to Powell’s dovish tilt, interpreting his openness to rate cuts as supportive of growth.

The S&P 500 rose approximately 1.5–1.6%, the Nasdaq Composite climbed nearly 2%, and the Dow Jones Industrial Average surged 1.9–2%, reaching a record intraday high. The rally reflected relief at the prospect of looser monetary policy, particularly for growth-oriented and rate-sensitive stocks.

U.S. Treasury yields fell, with the two-year Treasury yield dropping nearly 10 basis points to 3.69% and the 10-year yield declining 6 basis points to 4.27%. The yield curve steepened, with the spread between 5- and 30-year rates hitting a cycle high, reflecting mixed expectations for inflation and growth.

The U.S. dollar weakened against a basket of currencies, including the euro and yen, with the Bloomberg Dollar Spot Index falling about 0.4%. This reflected expectations of lower rates reducing the dollar’s appeal.

Options pricing indicated an expected S&P 500 move of about 0.8% in either direction, nearly twice the average daily move over the past month, underscoring the speech’s anticipated impact.

The market’s upbeat response contrasted with pre-speech jitters, as Wall Street had been on edge, with the S&P 500 declining for five consecutive days prior to August 22 due to uncertainty over Powell’s stance and disappointing retail earnings.

Conclusion

Powell’s Jackson Hole speech last week, signaled a potential shift toward rate cuts in September, driven by labor market concerns, but stopped short of a firm commitment due to persistent inflation risks from tariffs. Market experts and media viewed the speech as cautiously dovish, navigating a complex economic and political landscape. Markets reacted positively, with equities rallying, bond yields falling, and the dollar weakening, reflecting optimism about potential monetary easing. However, the lack of definitive guidance and ongoing political pressures left some uncertainty, with analysts bracing for volatility depending on future economic data and Fed actions.

I however do not see a significant impact of the US market reaction on the Indian markets in the near term. Any enthusiastic response to the elevated rate cut hopes might be met with some aggressive selling.

Back home, the Reserve Bank of India (RBI) has recently released a discussion paper listing proposals to suitably refine the extant monetary policy framework, to address emerging economic challenges, such as supply shocks, global uncertainties, and climate-related risks. More on this in my next post.

Wish the readers A Happy Ganesh Utsav. May the Lord of Intellect and Conscience, remove all our obstacles created by our greed, ignorance, ego, intolerance, lust, material attachment, etc., and bless us with wisdom, contentment and peace.

Thursday, July 31, 2025

Powell refuses to toe the Trump line, India stay guarded

The Federal Open Market Committee (FOMC) of the US Federal Reserve (Fed) maintained its policy rates at 4.25% to 4.5% range, by a majority vote. It was the first occasion since 1993 when two Fed governors voted against the majority decision. Fed governors, Michelle Bowman and Christopher Waller, wanted a 25bps rate cut at the meeting, concluded on Wednesday.

The majority decision of the Fed to not cut rates is apparently against the wishes and open demand for a rather drastic cut in the Fed policy rates by the US administration, especially President Trump.

Strong April-June quarter GDP data and July private payroll data perhaps weighed on the Fed decision. The Commerce Department’s advance gross domestic product (GDP) report on Wednesday showed growth of 3.0% for the April to June period, above the 2.5% growth expected. US GDP shrank by 0.5% in the January-March 2025 quarter. U.S. private payrolls also increased more than expected July, rising by 104,000 jobs in July 2025 after a revised 23,000 decline in June.

Powell stays defiant

The Fed chairman Jerome Powell stayed defiant, not showing any sign of conforming to the political wishes and sticking to his mandate of keeping the prices under control and making employment conditions strong. In the post meeting conference Powell emphasized that there is no place for the central bank to consider government financing needs when setting interest rate policy. He said, “we don't consider the fiscal needs of the federal government. No advanced economy central bank does that, and it wouldn't be good”. Further adding that “it wouldn't be good for the Fed to do so as it would compromise its credibility”.

Important to note that the Fed has faced aggressive pressure from President Trump to cut rates. Trump has been claiming that said a large move down in rates (300bps) is justified by several factors, including stable inflation and improving fiscal conditions. At $1.1 trillion in interest rate payments last year, the cost of managing government debt has more than doubled since 2020 and that’s in some part driven by the high rates the Fed has in place to cool inflation levels.

Trade policy impact, a key variable

While the market participants agreed that it is important for the central bank to maintain its autonomy and make policy decisions on the basis of available and expected data, in order to effectively keep the prices under check.

Though Fed officials said that they “continuing to weigh data to see how big changes in government import taxes are affecting the economy, as financial markets continue to eye a possible September easing in short-term borrowing costs”, Chairman Powell suggested that he would like to wait for more data on impact of trade policy on prices, before taking any decision on rate cuts. Powell said the central bank has “made no decisions” about a potential policy change in September. He added, “Higher tariffs have begun to show through more clearly to prices of some goods, but their overall effects on economic activity and inflation remain to be seen.”

The US administration is pursuing a volatile and aggressive trade policy, in order to reset the terms of trade with its trade partners. It is still far from clear how the situation will finally appear once all trade related issues are settled. While the President has claimed that many trade deals, including with the EU, have been signed and the US is already on course to collect more than US$300bn in additional import duties this fiscal, reports suggest that a fresh round of trade negotiations in Sweden between the U.S. and China failed to result in a major breakthrough following two days of talks. Vietnam has also denied signing any trade deal with the US, as claimed by the president.

On Wednesday, Trump also announced that the United States will impose a 25% tariff plus penalties on India starting August 1, citing the country’s purchases of Russian military equipment and energy.

The impact of the increased tariffs on the domestic economy and inflation would be only known in a few months.

India’s reaction to tariff

The Ministry of Commerce has issued a guarded statement in response to Trump's announcement of tariffs and penalties on Indian exports to the US. The press release issued last night read as follows:

“The Government has taken note of a statement by the US President on bilateral trade. The Government is studying its implications.

India and the US have been engaged in negotiations on concluding a fair, balanced and mutually beneficial bilateral trade agreement over the last few months. We remain committed to that objective

The Government attaches the utmost importance to protecting and promoting the welfare of our farmers, entrepreneurs, and MSMEs.

The Government will take all steps necessary to secure our national interest, as has been the case with other trade agreements including the latest Comprehensive Economic and Trade Agreement with the UK.”

Though the markets may react today to Trump's tariff announcement, it is too early to assess the impact. It is still not clear, whether key Indian exports like Pharma, that were part of a separate trade negotiation are also part of this 25% tariff announcement. The “penalty” is also a vague term at this point in time. A team of the US trade negotiators is scheduled to arrive in India later this month. It is possible that the tariffs are stayed till the negotiations are complete, or be reversed to a more favorable rate, just like it has been done in the case of South Korea yesterday.

This tariff announcement is at best a temporary measure, pending the finalization of a comprehensive trade deal likely to be finalized later this year.

I would therefore like to have more clarity before reacting to the tariffs. This includes not jumping to buy if the market falls sharply today.

Thursday, January 30, 2025

Fed pauses, says not in a hurry to cut more

In a keenly watched two-day meeting, the first after the inauguration of the new US President, the Federal Open Market Committee (FOMC) of the US Federal Reserve (Fed) decided to pause its kept federal fund rates in 4.25%-4.5% range, after cutting it overall by 1% over its three previous meetings. The decision to pause is governed by a strong and resilient labor market and persisting inflation.

In a post meeting press interaction, Fed Chairman Jerome Powell noted that “The unemployment rate has stabilized at a low level in recent months, labor market conditions remain solid, and Inflation remains somewhat elevated.” He further added that the Fed needs to see “real progress on inflation or some weakness in the labor market before we consider making adjustments.”

Most notably, he emphasized that we're meaningfully above the ‘neutral rate’. He said, “I have no illusion that anyone knows precisely how much that is and but having cut 100 basis points means that it's appropriate that we not be in a hurry to make further adjustments.” (‘Neutral rate’ is a fed rate that is considered neither stimulative nor restrictive of growth under the current circumstances.)

Higher for longer: The market participants have taken this to imply that the current rate cut cycle is certainly not over and may resume after a pause, as the Fed gathers more evidence on inflation. Nonetheless, analysts now appear less sanguine about the lower bound of the present rate cut cycle. The consensus amongst them is emerging that the long-term bottom rate may have risen to 3% from the earlier estimates 2.5%. The ‘Fed pause’ is also being influenced by uncertainties surrounding the new administration's direction - on fiscal, trade, and government spending matters. The Fed officials noted “they don't intend to react until policies reach the implementation stage and begin to impact incoming economic data”.

Markets: Post the Fed decision, stock prices ended lower (S&P500 -0.5%), USD marginally stronger (DXY +0.2%) and benchmark bonds stronger (US 10yr Yield -0.37%).

RBI: The ‘Fed pause’ has made the February 06^th rate cut by the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI), less certain. There are however more chances that RBI may change its stance to ‘accommodative’ from ‘withdrawal of accommodation’, signaling now growth is a priority over inflation.

Thursday, December 19, 2024

Cautious FOMC spoils the Santa party

The Federal Open Market Committee (FOMC) of the US federal Reserve (Fed) obliged the market consensus by cutting its overnight borrowing rate by 25bps to a target range of 4.25%-4.5%. One member of FOMC voted against the cut, preferring to maintain the status quo.

Noting the economic conditions, especially still elevated inflationary expectations and resilient growth, the Fed indicated that 2025 may see fewer cuts than the previously estimated number. “With today’s action, we have lowered our policy rate by a full percentage point from its peak, and our policy stance is now significantly less restrictive,” Chair Jerome Powell said at his post-meeting news conference. “We can therefore be more cautious as we consider further adjustments to our policy rate.”

The FOMC raised its projection for full-year 2024 GDP growth to 2.5%, from 2% in September. However, in the following years, the FOMC officials expect GDP to slow down to its long-term projection of 1.8%. The committee lowered its expected unemployment rate in 2024 to 4.2%, while headline and core inflation were pushed higher to 2.4% and 2.8% respectively, slightly higher than the September estimate and above the Fed’s 2% goal.

The resilient growth and elevated inflationary expectations would require the Fed to hike or hold rates in 2025. However, officials appear wary of keeping rates too high and risking an unnecessary slowdown in the economy.

Insofar as the Trump 2.0 policies and their impact on the growth are concerned, the Fed Chairman Jerome Powell prefers a wait and watch approach. IN the post FOMC meet press interaction he said, “We’re just not at that stage.” He further added, “We need to take our time, not rush and make a very careful assessment, but only when we’ve actually seen what the policies are and how they’ve been implemented.”

The financial markets reacted negatively to the FOMC decision. Dow Jones lost 1123 (2.58%). Falling for the tenth consecutive day, it has recorded its worst losing streak since an 11-day slide in 1974. The S&P500 (-2.95%) and Nasdaq Composite (-3.56%) fell even more. The benchmark 10-year treasury yields jumped 3.08% to 4.52%, the highest level since April 2024 and 90bps higher than their August 2024 lows. UST Index rose 1.2% to its highest level in almost three years. Gold prices fell 2.3%, taking the yellow metal below US$2600 level after 3 months.

Thursday, September 19, 2024

Fed covers ground with a stride, does not look in a rush

Ending the weeks of intense speculation, anticipation and debate last night, the Federal Open Market Committee (FOMC) of the US Federal Reserve started the latest monetary easing cycle with a 50bps fund rate cut. The Fed fund rate range now stands at 4.75-5.00% This is the first Fed rate cut since March 2020 and has come after a fourteen months policy pause.

No panic in the boardroom

Unlike the previous two rate cycles that started with a rather aggressive 50bps rate cut – first October 2008 post the Lehman collapse and second March 2020 post Covid-19 break out – this cut is apparently not a panic cut.

The Fed chairman sounded confident about growth and employment level. He emphasized that the central bank is not in a hurry to ease policy, as he sees no likelihood of an elevated downturn in the economy. He mentioned, “There’s nothing in the SEP (Summary of Economic Projections) that suggests the committee is in a rush to get this done.”

The Chairman categorically advised the markets to not take this 50bps cut as “new pace”. He said, “we’re going to go carefully meeting by meeting, and make our decisions as we go”.

The decision to cut was however not unanimous. In a rare dissent, one member (Michelle Bowman) voted for a 25bps. This could be seen as yet another sign of “no panic” in the Fed board room.

Committed to price stability without pain in labor market

Announcing a victory over inflation, Mr. Powell announced, “The U.S. economy is in good shape. It is growing at a solid pace. Inflation is coming down.”

As per the latest economic data release, the US GDP expanded at 3% annual rate in 2Q2024 with 4.2% unemployment rate (considered near full employment), and inflation at 2.2% in August 2024.

Outlining the latest policy objectives, he commented, “We’re trying to achieve a situation where we restore price stability without the kind of painful increase in unemployment that has come sometimes with disinflation”. Guiding the markets, he emphasized that investors should take the Fed’s 50bps rate cut as a sign of its “strong commitment” toward achieving that goal.

Neutral rate seen close to 3%

The FOMC members see cuts of 25bps each in November and December FOMC meetings; 100bps cut in 2025 and 25bps cut in 2026 – implying that the latest easing cycle may end with the Fed rate range of 2.75-3.00%.

The Fed Chairman also mentioned in the post FOMC press meet that the neutral rate is likely significantly higher than it was on the previous occasions.

Markets ended lower

Markets – equity, bonds and commodities – ended the day with marginal cuts post the Fed announcement; while the USD was marginally stronger. This could be an outcome of either (i) sell on news; or (ii) traders’ disbelief in what Fed says about the strength of the economy.

What now

In my view, this aggressive 50bps cut is more of a correction than an aberration. Perhaps the Fed realized that they are running slightly behind the curve and hence tried to catch up. I do not see it as a panic move and would not like to indulge in “there is more to it than what meets the eye” debate.

Unlike 2008, there is no corporate balance sheet crisis, no risk of global markets freezing, and unlike 2020 there is no shutdown necessitating fiscal and monetary profligacy. It is a normal rate cycle change in response to a normalizing economic cycle. Therefore, expecting a market reaction like 2008 (sharply down) or 2020 (sharply higher) may not be appropriate.

I feel the US markets will adjust to the new policy trajectory in a couple of weeks and move accordingly. The lower rates shall help arrest the decline in the US housing markets and consumer spending. The bond yields may come down and the hedge trade in gold may begin to unwind. The corporate discretionary spend may also normalize as the cost of borrowing eases. This could be a relief for the Indian IT services companies.

For India, I am not sure if the RBI will rush to cut in October meeting, but would not rule it out completely. Financials and commodities are two sectors that need to be watched closely, in my view.

In the next couple of months, the markets in India will be driven by the 2QFY25 earnings. Any disappointment could lead to a decent correction in the markets. For now, I do not see a need to make any change in my investment strategy. (More on this next week)

The major risk to the markets comes from geopolitics now. The situation in the Middle East is worsening by the hour. NATO and CRIK (China, Russia, Iran and North Korea) alliances are hardening their positions, both on trade and war, making the situation explosive. (More on this next week)

Tuesday, August 27, 2024

Staying put for now

The US Federal Reserve (Fed) Chairman Jerome Powell has provided the much-anticipated fuel to the US markets, which appeared running out of fuel after a shocking job revision. Speaking at the annual Jackson Hole symposium, he unambiguously hinted that “The time has come for policy to adjust” as “inflation has declined significantly. The labor market is no longer overheated, and conditions are now less tight than those that prevailed before the pandemic”. Though he qualified his remarks by adding, “the timing and pace of rate cuts will depend on incoming data, the evolving outlook and the balance of risks”.

These comments read with the minutes of the last meeting of the Federal Open Market Committee (FOMC) provide adequate ground to believe that—

(i) The current rate cycle has peaked out; and the next policy move will be a rate cut.

(ii) The policymakers are confident the spike in inflation that occurred in the aftermath of Covid-19 pandemic (massive cash stimulus fueling demand and logistic challenges causing break in global supply chains) has been successfully tamed.

(iii) The economy is no longer overheated as the pandemic stimuli have been gradually withdrawn, the job market has cooled down, and commodity prices are behaving normally.

Though Mr. Powell did not make it clear that the FOMC will cut rate in the next meeting scheduled to be held on 17-18^h September 2024; the market consensus is assuming it to be a certainty. The debate is now circling around how aggressive the Fed could be in their pursuit of policy easing. Though, Mr. Powell emphasized that the rate cut will be data driven, a majority of market participants are expecting a 25bps cut each on 18^th September, 7^th November and 18 December. Some aggressive estimates are building 50bps cut each in September and December.

I am not competent to comment on the dynamics of the US monetary policy and its implications for the global economy and markets. My concern at this time is limited to how does the likely change in the Fed’s policy stance affects my tine portfolio of investments, if at all.

In this context I note that—

· In its last meeting, the Monetary Policy Committee of the RBI retained its policy stance of withdrawal of accommodation and maintained the status quo on policy rates by a four to two majority vote.

One of the dissenting members, emphasized that “Global uncertainties continue. The Fed, in indicating a cut in its September meeting, pointed out that since monetary policy acts with a lag they can't afford to wait until they reach their inflation target before cutting. That lag may be responsible for the sharply adverse August jobs report that has stoked recession fears and created market volatility. That a series of small signals were ignored, may have led to a critical large one. Monetary policy needs to act well in time. Spillovers led the global manufacturing PMI into contraction zone in July at 49.7.” (See here)

The other dissenting member was even forceful in his dissent, stressing, “For the last several meetings, I have been expressing concerns about the unacceptable growth sacrifice induced by a monetary policy that is excessively restrictive. The majority of the MPC however do not share this concern, perhaps because they think that the Indian economy is already growing at close to its potential growth rate. I think that such a view reflects (a) an unwarranted pessimism about the growth potential of the economy and (b) an overly sanguine expectation about growth in ensuing quarters. I disagree with both prongs of this assessment.” (See here)

This clearly highlights that despite being warned of the perils of running behind the curve and impairing the growth potential, the MPC decided to retain its stance. Maybe the RBI is not as sanguine about the price stability and growth potential as some of the members of the MPC.

· The fourteen-month gap (July 2023 to September 2024) between the Fed pause and the first cut would be the second longest in the past five decades. The markets have been anticipating a Fed rate cut for almost a year now.

In this period, the stock markets, both the US and the Indian, have not witnessed any meaningful correction and are already at an all time high level. The question is whether the anticipated rate cut would provide immediate impetus to the markets; or the markets will be worried about further deterioration in economic growth.

It is pertinent to note that empirical evidence suggests that in the past three rate cycles, the US market has fallen 12 to 50% during the Fed rate cuts.

· The governments in the US and India are not in a position to back up the monetary policy easing with fiscal stimuli.

Under the circumstances, for now I am more inclined to assume that:

· It is not certain that the RBI will immediately follow the US Fed in cutting rates, unless strong evidence of growth collapsing emerges. Rise in the yield differential may attract stronger flows and support USDINR and markets.

· A weaker USD may support commodity prices

· A panic cut by RBI on the other hand may adversely affect the margins of banks (loans get repriced immediately while deposits take longer; CD ratio faces further pressure); and also affect the overall sentiments.

· The earnings momentum appears to have slowed down in 1QFY25. A sharp cut by RBI might arrest the slowdown in earnings momentum; and also help higher equity valuations to sustain.

· Negative real rates may adversely affect savers (consumption) and support capex.

I will review my portfolio in accordance with these assumptions in the next review. For now, I am just staying put.

Tuesday, May 28, 2024

FOMC stops just short of dropping the “H” word

The minutes of the last meeting (30 April 2024 – 1 May 2024) of the Federal Open Market Committee (FOMC) of the US were released last week. The discussion provides a decent insight into the policymakers’ thought process about the near-term economic outlook and the likely policy direction.

In my view, the most notable part of the FOMC discussion was the mention of a scenario that may warrant further tightening of policy. Though the participants may not have specifically mentioned the term “Rate Hike” it was very close. The minutes read, “Various participants mentioned a willingness to tighten policy further should risks to inflation materialize in a way that such an action became appropriate.” This is perhaps the first time in the past six months that FOMC participants have explicitly mentioned the likelihood of policy tightening.

The FOMC participants noted that data indicated continued strong economic growth. They, therefore, sounded circumspect about the restrictiveness of the current policy stance. They noted some progress on the inflation front, but found the data pointing “to inflation being more persistent than previously expected and to a generally resilient economy”.

The participants noted that the market expectations from the policy has shifted materially in response to the resilient economic growth and persistent inflation. “The policy rate path derived from futures prices implied fewer than two 25 basis point rate cuts by yearend. The modal path based on options prices was quite flat, suggesting at most one such rate cut in 2024.”

Some of the notable points in the FOMC minutes could be listed as follows:

· Model estimates suggested that inflation expectations rose some, but mostly at shorter horizons. Longer-term inflation expectations appeared to remain well anchored. The possibility that geopolitical events could generate commodity price increases, pose an upside risk to inflation. It would take longer than previously anticipated to gain greater confidence that inflation was moving sustainably toward 2 percent.

· The recent monthly data has shown significant increases in components of both goods and services price inflation. The disinflation process would likely take longer than previously thought. Increased efficiencies and technological innovations could raise productivity growth on a sustained basis, which might allow the economy to grow faster without raising inflation

· The dollar strengthened as several foreign central banks were expected to start easing policy before the Federal Reserve.

· The valuations across a range of markets appeared high relative to risk-adjusted cash flows. The assessment of vulnerabilities in asset valuations is raised to elevated.

· Labor demand and supply continued to move into better balance, though the speed of this realignment appeared to have slowed in recent months.

· Foreign GDP growth is estimated to have picked up in the first quarter from its subdued pace in the previous quarter. In Europe, economic activity resumed expanding following modest contractions in several economies amid monetary policy restraint and the repercussions of the 2022 energy shock. Growth stepped up in China, led by strong exports, but property-sector indicators remained weak. Elsewhere in emerging Asia, exports rebounded further from last year’s lows, lifted by robust global demand for high-tech goods.

· The risks around the forecast for economic activity were seen as skewed to the downside on the grounds that more-persistent inflation could result in tighter financial conditions than in the staff’s baseline projection; in addition, deteriorating household financial positions, especially for lower-income households, might prove to be a larger drag on activity than the staff anticipated.

· A range of risks are emanating from the banking sector, including unrealized losses on assets resulting from the rise in longer-term yields, high CRE exposure, significant reliance by some banks on uninsured deposits, cyber threats, or increased financial interconnections among banks.

· Although monetary policy is seen restrictive, many participants were uncertaint about the degree of restrictiveness. They saw this uncertainty as coming from the possibility that high interest rates may be having smaller effects than in the past, that longer-run equilibrium interest rates may be higher than previously thought, or that the level of potential output may be lower than estimated.

My impression from the FOMC discussions is that even though the ‘Rate Hike’ is not mentioned in the minutes; it is clear that the status quo might last longer than anticipated (higher for longer). There is a fair degree of uncertainty over the Fed's next move. Presently the market is forecasting a 25-50 bps cut in the Fed’s target range for bank rate, a 25bps hike in the next 12 months cannot be completely ruled out.

Friday, February 2, 2024

Sitharaman, Powell toss the ball in Das’s court

Wednesday night, the Federal Open Market Committee (FOMC) decided to maintain the status quo on policy rates for the fourth successive review. The Committee reiterated that it “does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward two percent.” The Committee however made it quite clear that any rate hike from the present level is no longer on the table.

In the post-meeting press meeting, Fed Chairman Jerome Powell indicated that FOMC may not consider rate cuts in its next meeting in March 2024. The market is thus expecting a rate cut in May 2024.

In another development, the Union Finance Minister, Ms. Nirmala Sitharaman, presented an interim budget for the fiscal year 2024-25. Two notable features of the interim budget were (i) Nominal GDP growth projection for FY25 at 10.5%, implying a well-controlled inflation environment; and (ii) Fiscal deficit of 5.1% of GDP for FY25BE, implying a strong commitment to fiscal discipline.

In line with the lower fiscal deficit projection, the borrowing program of the government has also been moderated. The finance minister has proposed Rs11.75trn of net borrowing from the market by way of fresh government securities in FY25BE against Rs11.80 borrowed in FY24RE. This shall leave decent scope for private investment.

In her speech, the finance minister also emphasized the supportive environment her government is building for acceleration in private capex to achieve the high growth targets. The minister has provided higher allocation for production-linked incentives (PLI).

With the global rate and monetary policy environment set to become benign in 2H2024; domestic macro (fiscal deficit, inflation, external conditions, etc.) improving and the government holding its side of promise to maintain fiscal discipline despite forthcoming general elections, the ball is now in the court of the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) to provide impetus to the economic growth.

The risks to inflation now mostly stem from food (inclement weather) and energy (geopolitical disruptions) which may not have a significant correlation with the policy rates. It would therefore be in order for RBI to guide a lower rate path and increase system liquidity.

The MPC meeting next week therefore will be watched with keen interest. I would not expect any immediate rate cut (though it will be welcome if happens), a clear guidance for lower rates going forward and enhanced system liquidity is what I do expect from MPC. If RBI delivers on these expectations, markets could rally to new highs led by financials and rate-sensitive sectors like auto and real estate.

Thursday, November 2, 2023

Fed leaves it to markets to find their equilibrium

As widely expected, the Federal Open Market Committee (FOMC) of the US Federal Reserve, unanimously decided to keep the key fund rates at 5.00% - 5.25% for the second consecutive time. The FOMC had last increased the rates in July 2023.

The Committee noted, "Economic activity expanded at a strong pace in the third quarter". It also acknowledged “the tighter financial conditions faced by businesses and households”. Upgrading its outlook for the US economy, Fed Chairman Jerome Powell remarked, “The process of getting inflation sustainably down to 2% has a long way to go”.

After the last meeting in September 2023, the monetary policy statement issued by the FOMC had noted that “credit conditions have tightened” consequent to the eleven consecutive hikes delivered by the Fed. This time, the Committee added “financial” to the credit conditions, noting the rising stress in the financial system as a consequence of rising bond yields.

Caught between the resilient economy and building stress in the financial system, the Federal Reserve seems to have decided to stay on the fringe and let the markets find their equilibrium.

Though, the post-meeting FOMC statement reads, “committee is still determining the extent of additional policy firming” and “The Committee will continue to assess additional information and its implications for monetary policy,” the consensus in the market is leaning towards “a long pause” followed by a series of cuts; assuming the Fed is done with hiking and it will now wait for the market forces to find an equilibrium on prices and growth.

Whitney Watson, co-CIO of fixed income and liquidity solutions at Goldman Sachs Asset Management, reportedly commented it’s likely the Fed will keep its policy unchanged into next year. “There are risks in both directions,” Watson said. “The rise in inflation expectations, owing to higher gas prices, combined with strong economic activity, preserves the prospect of another rate hike. Conversely, a more pronounced economic slowdown caused by the growing impact of higher interest rates might accelerate the timeline for transitioning to rate cuts.”

Post the release of the FOMC statement, the yield on the two-year Treasury, which is more sensitive to Fed policy, fell 12.5 basis points to 4.93%, the lowest level since September 2023. Stocks also rallied with S&P500 and NASDAQ ending the day with over one percent gains.

Thursday, September 21, 2023

Fed pauses; keeps the window open for further hikes

The Federal Open Market Committee (FOMC) of the US Federal Reserve (the Fed) decided unanimously to keep the benchmark fund rate in the range of 5.25% - 5.5%; pausing one of the sharpest hike cycles in the past four decades. Beginning in March 2022, the Fed has hiked the benchmark rate 11 times to the highest since 2001.

The latest FOMC decision may be influenced by the recent evidence showing that the hikes already implemented are beginning to impact inflation, despite strong economic outcomes. Notwithstanding, its latest decision to pause, 12 out of 19 FOMC members felt that one more rate hike would be needed in 2023 before the current rate hike cycle ends, as inflation is still running above the Fed’s 2% target. The persistent strength in the economy requires caution as inflation might bounce back again.

In particular, FOMC members sounded cautious about the tight labor market, as wage growth has so far accounted for the bulk of price pressures in the service sector,

Higher for longer

Speaking at the post-meeting press conference, Fed Chairman Jerome Powell, cautioned that "Holding the rate doesn't mean we have reached the stance we seek”. The committee projects the median Federal Funds rate at 5.1% in 2024, higher than its June estimate of 4.6%, suggesting that rates will remain higher for longer than earlier projections.

The FOMC members now see a couple of rate cuts in 2024, against four rate cuts projected previously. For 2025, interest rates are expected to drop to 3.9%, well above the 3.4% previously projected, and fall further to 2.9% in 2026.

Economic growth forecast upgrade

Taking cognizance of the persistent strength in the economy, FOMC upgraded its economic growth forecast for 2023 to 2.1% from the previous 1% rate projected in the June 2023 meeting. The growth forecast for 2024 was also raised to 1.5% from the previous 2.1%.

Yields spike, curve inverted

Post the announcement of the FOMC decision, the US bond yields rose to cycle highs. The benchmark 10-year G-Sec yields ended at 4.395%, while the more sensitive 2yr yields were at 5.17%. The US treasury bond yield curve is now sharply inverted, indicating market expectations of much slower growth, if not full-blown recession in the offing.

Equities correct led by big Tech

The US Equities corrected over 1% from their intraday highs, post the FOMC decision. The fall was led by the growth sectors, especially the big technology companies like Alphabet (-3%), and Meta Platforms (-1%) and Apple (-1%).

Tuesday, August 29, 2023

Sailors caught in the storm

I have often seen that when we fail to find solutions to our problems with the help of science and economics, we tend to look towards the heavens and seek to find answers in philosophy. It is not uncommon for businesses, administrators, and policymakers to seek divine intervention when science and economics are not helping to resolve a problem. The global policymakers and administrators seem to have reached such a crossroads one more time, where the conventional practices, accumulated knowledge, and past experiences do not appear to be of much help. Their actions appear driven more by hope than conviction.

The war in Ukraine; the economic slowdown in China; and the monetary policy dilemma in the US and India are some examples of problems where the administrators and policymakers seem to be hoping for divine intervention. I see the recent speech of the US Federal Reserve Chairman Jerome Powell at the Jackson Hole symposium and the minutes of the last meeting of the monetary policy committee of the Reserve Bank of India in this light.

After 16 months of aggressive monetary tightening, the Fed is not confident whether they have done enough; or they have overdone with tightening or they are lagging behind. He reiterated that the policy is restrictive enough to anchor inflationary expectations, but still expressed fears that the high inflation might get entrenched in the economy and may require treatment at the expense of higher unemployment. Chairman Powell indeed sounded more like a sailor trapped in a storm, when he said, “We are navigating by the stars under cloudy skies”.

The situation in the US, as I see it from thirty-five thousand feet above sea level, is as follows:

· The US Federal Reserve has hiked the key policy rates from near zero (0.25%) in March 2022 to 5.5% in August 2023. This is one of the steepest hikes in the past four decades.

· The US financial system faces a serious challenge as MTM losses on the bond portfolios are accelerating; retail delinquencies have started to build up;

· The positive real rates in the US are now 2% or higher. Despite these restrictive rates, the economy is not showing much sign of cooling down. The probability of growth acceleration in the US economy in the next couple of years is therefore remote.

· Inflation continues to persist above 4% against a committed target of 2%. The household savings may therefore continue to shrink at an accelerated pace.

· The mortgage rates are well above 7%, the highest in two decades. Housing affordability is at its worst in history.

· The US government is paying close to US$1trn/year (about 20% of revenue) in interest on its borrowing, which is an unsustainable level.

· The cost of borrowing (and interest burden) for the US government shall continue to rise for a few years at least as the Fed reduces its balance sheet, foreign governments cut on their demand for the US treasuries, and the rating of the US government’s debt face further downgrades. The fiscal pressures thus remain elevated.

· The money supply (M1) in the US at US$19trn is about 4.5x of the pre-Covid levels. It may take years to normalize at the current speed of quantitative tightening (QT) by the Federal Reserve.

·
The “Lower for Longer” narrative has metamorphosed quickly into “Higher for Longer”. However, analysts, economists, and strategists who are in their 30s may have never witnessed a major rate or inflation cycle in their professional careers. Their assessment of peak rates and peak inflation may be suffering from some limitations.

….to continue tomorrow