Fed Rate Hike, Its implications

The Fed has acted finally to revise the target fed funds rate by 0.25%, taking the rate to the range of 0.25% to 0.50%. The last such hike was in December 2018. This move by the Fed is exactly on expected lines and there is no surprise element in this at all. The actual rate hike comes after a prolonged period of introspection on the behaviour of the price level or inflation. The Fed was of the view that inflation was transient and that it was a passing phase, the result of the unleashing of the pent-up demand after the shutdowns during the pandemic. But inflation numbers month after month proved the Fed wrong, and this led to three developments in quick succession – the acceptance that inflation was going to stay high for a longer than expected time period, the acceleration of the roll back of the bond buying program, which originally was a monthly US$ 120 billion bond purchase program, and finally, the decision to go ahead with rate hikes. Therefore, the Fed policy evolved into this fruition over the last three quarters.
With the rate hike, the Fed has also given some guidance on the future trajectory of economic growth and inflation. This is more interesting, and probably more important, than the rate hike itself because the professional response in the markets and portfolios will, to a significant extent, will be based on this. The Fed has indicated a likely six hikes during the rest of the year. This implies a rate hike every time the FOMC meets. There are likely three hikes next year, 2023, and none for 2024. This is quite an aggressive approach to rate hikes in a bid to combat inflation. The forecast for growth is more thought-provoking

-2.8% growth in 2022, as against the earlier forecast of 4% put out in Dec21, and 2.20% for 2023. This is
substantial fall, and it may also imply sacrificing quite a bit of growth for contain inflation. The 40- year high inflation levels moved up beyond the 7 % mark in the last couple of months. It was projected to be around 2.60 % on an average for the current year but has been has now revised upwards to 4.30 %.
In addition to these measures, Fed would also begin the process of shrinking the balance sheet, and become asset light, in the next two months. This again, is effectively an act of tightening. The aggressive stance is likely to bring some pain for the economy and the markets. The benchmark 2 -year treasury note moved up to 2 % as soon as the rate decision was announced. The shift in the policy stance and the advent of the tightening season, will make the US Dollar stronger against the currency majors. It may also bring in some moderation in commodity prices. The exit from emerging markets and the shift into US Dolar denominated assets may gather pace in the immediate term. Other economies facing inflationary pressures, like the European countries and also larger economies like India, will not be able to ignore the need to control inflation through rate action. The higher currency yield on the US Dollar, may lead to a stronger Dollar, and this may result in some moderation in the prices of commodities like oil and gold. Some comfort can be drawn from this for economies which are high on oil imports for inflation moderation.



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