Vijay Kumar Gaba

The Federal Open Market Committee (FOMC) of the US Federal Reserve (Fed) has decided to hike the target for the benchmark federal funds rate to a range of 3.75% to 4%, its highest level since 2008. It is an unprecedented fourth hike of 75bps each at the consecutive meetings. The Committee indicated that “ongoing increases” would still likely be needed before the rates become “sufficiently restrictive” to slow down the inflation.

In a post meeting press statement, the Fed Chairman Jerome Powell said, “incoming data since our last meeting suggests that the ultimate level of interest rates will be higher than previously expected.” He added that it was “very premature” to discuss when the Fed might pause its increases.

Further hikes could be lower than 75bps

The FOMC statement promised to take economic risks more clearly into account in deciding the size of any further rate increases. The FOMC statement read, “in determining the pace of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments."

The statement is being widely interpreted to mean that the future hikes, from the FOMC’s December 2022 meeting onwards, could be lower than 50bps. Though no dot plot (a traditional indicator of Fed official’s view on future rate hikes) was released after the meeting.

No recession, but less chance of a soft landing

Chairman Powell expressed hope that the U.S. economy can escape a recession as the Federal Reserve raises interest rates to lower inflation. He was however skeptical about the soft landing of the economy. He said that given the persistence of price pressure this year, the window of opportunity for a "soft landing" has narrowed; though he is still hopeful of a soft landing.

"Has it narrowed? Yes," Powell said at a press conference after the Fed's latest rate hike. "Is it still possible? Yes."

It is pertinent to note that signs are emerging in the US economy that a hard landing is now probable. The latest PMI came at 45. The stress in households is becoming more evident as personal savings are collapsing; credit card debt is rising at a much faster rate; over a third of the small businesses are unable to pay rent on time. The larger engine of the US economy, the consumer, has already started to stutter.

Markets disappointed

Stock markets corrected sharply after the Fed’s decision, with benchmark S&P500 shedding 2.5% and Nasdaq Composite diving 3.6%. Volumes were large as the market dived post Powell’s press statement, indicating heavy unwinding of positions.

US Dollar Index (DXY) ended more than half of a percentage point higher to close above 112.

Gold and Bitcoin were lower.

The Benchmark 10yr treasury yields were higher by 87bps at 4.10%.

There is an old legend. From time to time, numerous versions of this legend have been narrated by wise people to highlight the adverse effects of not admitting the mistakes early enough; indecision; and failure to assess the gravity of an adverse situation. One version of the legend goes like this—

Once a thief was caught stealing a sack of onions from a farmer’s house, and was produced before the magistrate. On asking, the thief first pleaded “not guilty”. After a trial the magistrate found him guilty of stealing and allowed him to choose his punishment from the following three options – (i) Pay five gold coins to the farmer; (ii) eat hundred onions from the sack he tried to steal; or (iii) get whiplashed hundred times.

The thief chose to eat the hundred onions, without giving it a thought, assuming it to be the easiest one. However, after eating just twenty five onions, he was in tears. His stomach started to burn and refused to take anymore. He begged the magistrate to change his punishment to a hundred whiplashes. The magistrate allowed his request and ordered his men to whiplash the thief a hundred times. After taking twenty five lashes his skin started to come off and pain started to become unbearable. He again implored the magistrate to stop his men and allow him to eat onions. The magistrate agreed to his request. He ate another twenty five onions and could see the grim reapers (Yumdoot) standing right in front of his eyes. He now pleaded to the magistrate to allow him to pay five gold coins. Had you stopped for a couple of minutes to think about the options presented to you, you would not have suffered so much the magistrate chided him, agreeing to his request.

The moral of the story is that if the thief had admitted his mistake early, the magistrate could have let him off with a milder sentence. He chose a sentence which he had no clue about, rather than opting for the clearly defined monetary fine. Also, despite suffering once, he still did not opt for the right option and suffered an avoidable twenty five lashes and twenty five more onions.

The situation of the Reserve Bank of India (RBI) is somewhat similar to the thief in the legend. It refuses to admit that it has been confused between growth and inflation for long. It also refuses to accept that in the present situation the factors driving the inflation are mostly beyond its control; and it can only manage a small part of the inflation by hurting the growth significantly and imperiling the financial stability!

Palpably, the out of turn rate hike by RBI is aimed to protect the INR. The fear of the larger outflows, as other central bankers hike rates aggressively, appears to have prompted the RBI to make a preemptive hike. The currency market though does not appear impressed by the RBI move, and INR has weakened to its lowest level ever. The outflows have continued in the equity as well as debt market, despite higher yields (bonds) and lower valuations (equity). The RBI might thus have wasted one important arrow (40bps rate hike) in its quiver.

The situation is vividly reminiscent of the current account crisis of 2012-2013. The INR witnessed violent volatility and outflows were strong in light of taper tantrums. The rate hikes at that time did not help much and we were very close to a balance of payment crisis. The RBI changed its approach in September 2014 and an imminent disaster was averted, but not without some serious damage to the financial stability and growth ecosystem.

I assume this time we will not be driven to the brink like 2013, and the crisis will be mitigated soon. For now we are eating onions only. I hope the economy will be spared whiplash and gold coins.