Why are markets looking forward to the first pause in rate hikes by the US Fed since Jan 2022?

US stock investors, who until just weeks ago were betting that the Fed would likely commence slashing rates in the coming months, now expect that the US central bank’s benchmark short-term rate – which acts as the peg for most consumer and business loans in the US – is likely to remain high for the rest of the year, given that both inflation and the job market remain way more resilient than expected. But what lends credence to this expectation of a skip are a couple of statements by Fed Chair Jerome Powell over the last month.

On May 19, Powell said that it was “still unclear if US interest rates will need to rise further”, as central bank officials “balance uncertainty about the impact of past hikes in borrowing costs and recent bank credit tightening” with the fact that inflation is proving hard to control. In a scripted remark at a research conference where Powell was interviewed by a US central bank staffer, the Fed chair asserted that bank officials “can afford to look at the data and the evolving outlook to make careful assessments.”

Just a little over a fortnight prior to that, Powell had thrown another hint. “Looking ahead, we’ll take a data dependent approach in determining the extent to which additional policy firming may be appropriate… But the strains that emerged in the banking sector in early March appear to be resulting in even tighter credit conditions for households and businesses. In turn, these tighter credit conditions are likely to weigh on economic activity, hiring and inflation. The extent of these effects remains uncertain. In light of these uncertain headwinds, along with monetary policy restraint we’ve put in place our future policy actions will depend on how events unfold”, he asserted at a May 3 meeting of the Federal Open Market Committee – the Fed’s key rate federal setting body that is equivalent to the RBI’s Monetary Policy Committee.

Multiple other Fed representatives have since echoed the line that they would be open to watching the incoming data. While the US jobs report continues to be stronger than forecast and the consumer price index report – the key inflation benchmark – is expected to come in later on Tuesday and is another important factor. And the Fed outlook could set the trend for central bank action during the rest of the week, with the Bank of Japan, the European Central Bank and the Peoples Bank of China meetings slated for later this week.

Is a hike still possible?

Some still think a hike is on the table, even though that view is getting less traction. One reason is the impact of the multiple rate hikes on the US banking sector. Kevin Maxwell Warsh, who served as a member of the Federal Reserve Board of Governors from 2006 to 2011 and is now a Hoover Institution Visiting Fellow, in an op-ed in The Wall Street Journal earlier this month talked about the fallout from the Silicon Valley Bank collapse and argued that without a change in policy, the US banks could face a slowdown and need even more government support. Warsh has overwhelmingly pushed for “using this moment to protect ourselves and protect the banking system”.

Powell, in his May 3 statement, touched upon the situation in the US banking sector and asserted that “conditions in that sector have broadly improved since early March and the US banking system is sound and resilient”. “We will continue to monitor conditions in the sector. We’re committed to learning the right lessons from this episode. And we’ll work to prevent events like these from happening again”.

From the monetary policy perspective, Powell said the Fed’s focus “remains squarely on our dual mandate to promote maximum employment and stable prices for the American people”. And while he asserted that he and his colleagues “understand the hardship that high inflation is causing and we remain strongly committed to bringing inflation back down to our 2 per cent goal”, he underlined that looking ahead, the Fed will “take a data dependent approach in determining the extent to which additional policy firming may be appropriate”.

The data points

What are these data points? So, the US economy had slowed significantly last year, with real GDP rising at a below trend pace of 0.9 per cent. The pace of economic growth in the first quarter of this calendar year continued to be a modest 1.1 per cent. Also, despite a pickup in consumer spending, activity in the American housing sector remained weak, largely reflecting higher mortgage rates and higher interest rates. Slower output growth also seems to be weighing on business fixed investment. And the really important metric, the labour market activity, remains rather tight.

Over the first three months of 2023, the job gains averaged 345,000 jobs per month – a very strong showing– while the unemployment rate remained very low in March at 3.5 per cent. For mounting an effective response though, the problem for policy mandarins in Washington is the continuing buoyancy in the US job market. The failure of the labour market to soften had added to the impetus for a more-aggressive tightening path at the US central bank so far.
But significantly, Powell, in his May 3 address, underscored the point that “there are some signs that supply and demand in the labour market are coming back into better balance” and that “nominal wage growth has shown some signs of easing and job vacancies have declined so far this year”. But overall, the labour demand still substantially exceeds the supply of available workers, something that the Fed has been desperate to cool before slamming the brakes on its rate hiking spree.

Political implications

While a resilient economy, and the continued strength exhibited by the American job market, offer President Joe Biden a boost in the build-up for his reelection bid, there is also some amount of trepidation in the political circles that the high interest rates could impact indebted households and smaller firms much more. More importantly, any escalation of the banking crisis could dent optimism further and impact Biden’s prospects. So, a move towards a skip or a pause by the Fed increases the chances that the economy could slow gradually – towards a soft landing — rather than descending sharply into recession. The harder the landing, the more detrimental it would be for Biden’s reelection chances.

Impact across markets

Like other central banks such as the Reserve Bank of India, as the US Fed conducts monetary policy, it influences employment and inflation primarily by using policy tools to control the availability and cost of credit in the economy. Interest rate hikes are the primary monetary policy tool used by central banks to tackle spurts in inflation. When interest rates go up in an economy, it becomes more expensive to borrow; so households are less inclined to buy goods and services, and businesses have a disincentive to borrow funds to expand, buy equipment or invest in new projects. A subsequent lowering of demand for goods and services ends up depressing wages and other costs, in turn, bringing runaway inflation under control. Even though the linkages of monetary policy to inflation and employment are not direct or immediate, monetary policy is a key factor in tackling runaway prices.

Theoretically, a pause – or a long skip – in the US after an extended rate hiking spree should be a positive for emerging market economies, especially from a debt market perspective. Emerging economies such as India tend to have higher inflation and, therefore, higher interest rates than developed countries. As a result, investors, including Foreign Portfolio Investors, tend to borrow in the US at lower interest rates in dollar terms and invest that money in the bonds of countries such as India (rupee denominated) to earn a higher rate of interest.

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A pause in the hike in rates in the US could have a three-pronged impact. If the Fed pauses its policy rates and subsequently moves to cut rates, the differential between the interest rates of the US and a second country would either remain steady or widen, thus making the other country more attractive for the currency carry trade (leveraging the interest rate arbitrage). A pause by the Fed would also mean a higher impetus to growth in the US, the world’s biggest economy, which could be positive news for global growth. Lower returns in the US debt markets could also trigger a churn in emerging market equities (EMEs), increasing foreign investor enthusiasm. There is also a potential impact on currency markets in EMEs, stemming from possible inflows of funds.