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Below is quote on US FED pivots, RBI to follow - Q India Insights By Arvind Chari, CIO- Quantum Advisors

US FED pivots, RBI to follow - Q India Insights

The year end parties in the financial circles will be abuzz discussing this hawkish tilt by the US Federal Reserve (FED).

We believe this announcement by the FED will have a significant impact on financial markets and asset prices in 2022.

The FED has signalled a shift towards prioritising inflation over its other goals of employment and stable growth.

Not only did they announce an end to its QE program (bond purchase) by mid-March 2022, the change in the ‘dot-plots’ suggests that the FOMC members now expect 3 rate hikes in 2022 and 2023 respectively.

Two comments from the FED chairman in the press conference suggests that the FED will continue on the path of monetary tightening – a) ‘the world is learning to live with COVID’ as an indication that normal impact to growth from Omicron will be ignored and b) ‘high inflation is the biggest threat to full employment’ – suggesting that the priority now is managing and getting inflation back to the 2% level.

This is a clear change in stance by the FED. It is also indicative of the fact that the economy is no longer in a crisis and that monetary policy need to move away from crisis time actions.

Time for RBI to change it’s monetary policy stance

This has implications for India and the RBI. Despite an increase in inflation, the RBI has maintained its accommodative stance and kept interest rates at crisis time levels.

As we noted in our recent insight piece, the Indian economy has recovered better than expected and is 
on the cusp of a sustained revival. India is not in a crisis

The RBI though was surprisingly ‘dovish’ in its December policy and we were perplexed with its lower inflation projections.

However, with domestic price pressures rising and a ‘hawkish’ FED, the RBI will be forced to change its stance and begin hiking interest rates.

The RBI has another challenge. A hawkish FED, relative to other developed central banks, would also mean that the US dollar could strengthen. The RBI then will be tested in its priority of controlling the exchange rate or being true to its inflation mandate. Recent moves in the INR suggests that the RBI will focus on inflation and liquidity and allow the INR to depreciate. Some amount of depreciation is also a natural adjustment for the higher trade deficit and recent FPI outflows.

Sudden Shifts

Normal rate increases which are well communicated will be absorbed and priced in the markets. Bond yields as seen for eg from the 2-5 year curve across the globe had started rising and thus pricing in the eventual rate hikes. We may continue to see a gradual increase in yields as central banks increase rates and reduce liquidity. Even equity markets can deal with these rate hikes given that the growth outlook remains positive.

Long-term bond yields and equities though face risks from a sudden change in stance from central banks. India faces this risk from an increase in oil prices or a rise in food prices. This would force the RBI to hike interest rates sharply and markets could face higher volatility.

Globally, the biggest risk for the markets will stem from the US FED beginning to reduce the size of its balance sheet. This means that the US FED will be taking liquidity away from the markets.

The fact that this was discussed in the December FOMC meeting, suggests that, if conditions persist, the FED may not only hike rates but also begin the process of allowing bonds that it holds to mature and/or selling bonds to reduce the size of its balance sheet.

This scenario is not priced in the markets and will be a big scare for risk assets especially in emerging markets which have been a beneficiary of global liquidity.

Also, this is not all that far-fetched. In 2017, the US FED stopped replacing bonds that matured in order to reduce the size of its balance sheet along with continuing its rate hikes. This did have an impact in the markets in 2018/2019.

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