The US Fed & ECB Likely To Lead Decisive Pivot In Global Interest Rates; Will India Follow Suit?

Mindful of the Fed’s dual mandate of stable prices and maximum employment, he noted: “the upside risks to inflation have diminished. And the downside risks to employment have increased”. He emphasised that his “confidence has grown that inflation is on a sustainable path back to 2 per cent”.

The US Fed's decisions and its forecasts on global inflationary trends carry weight with central bankers around the world including of course India's Reserve Bank of India. With the RBI's MPC split on keeping interest rates steady (two members voted for a cut), the US Fed's decision will be keenly watched in Mint Street. 

This was very different from the earlier language that the Fed “needs to be more confident that inflation…”. This message has been reinforced by other Fed officials in their comments. The nuances of central bankers’ language are key methods of communicating “forward guidance” on future rate actions. 

It is also striking that the Fed, the overseer of monetary policy of the US economy (which remains the strongest economy in the world despite decelerating), has turned more dovish than many of its counterparts (European Central Bank (ECB), Bank of England (BOE) and others) whose jurisdictional countries are economically far weaker now.

Recall that the Fed has been one of the last major central banks to start cutting rates. The ECB and BOE had already made their first rate cuts. Markets are now pricing the Fed Funds Rate (FFR) at 4.25 per cent at end-2024 and 3.1 per cent by end-2025.

The FOMC’s own dotplot projections at its June meeting showed FFR at 5.1 per cent and 4.1 per cent by end-2024 and 2025, respectively. The forthcoming September meeting will provide updates of their projections and will be keenly watched. 

The sequence of macro-financial events which led to the Fed’s dovish pivot and the likely paths of monetary policy rate cuts of the major central banks by end 2024 and 2025 is important to consider. This sequencing will partially determine the space available for policy easing in emerging markets including India. 

Everything, Everywhere, All At Once

Was it just the (much weaker than expected) July jobs numbers that led to this volte face in the Fed’s communication? It certainly added to the looming recession narrative, but there were likely other worries. 

Nowhere was this change of expectations more stark than in the US. Multiple data releases have sequentially painted a mixed, even conflicting, picture of the resilience of the economy. At August beginning, weaker than expected jobs data led to a large re-rating of US “soft landing” prospects to a recession.

Markets changed their earlier shallow Fed rate cuts expectations. This was then reinforced by lower July CPI and wholesale inflation. However, lower jobless claims for 2 weeks in a row has again shifted the narrative to continuing resilience in labour markets. 

If this economic uncertainty was not enough, central banks have had to contend with a spike in financial markets volatility. August saw an unusual convergence of shocks roiling global markets. The US employment data jolt was followed by an unexpected hike in the policy rate by the Bank of Japan, accompanied by a hawkish commentary by the Governor, resulting in a sharp appreciation of the Yen-Dollar exchange rate.

This led to a rapid unwinding of “carry trades” in the Japanese Yen (borrowing Yen cheap to invest in higher interest rate countries), affecting global equities markets. China added to this with an unexpected cut in its key policy rate. Heightened geopolitical tensions in the Middle East completed the trifecta. The US Dollar saw large swings, affecting global foreign exchange markets. 

In comparison, economic weakness in the Euro area is much more evident and long running, but even here uncertainty about last mile inflation, particularly services inflation, keeps the ECB unable to signal its future rate cut path that remains future data-dependent. 

Post the early August turmoil, “financial conditions” in the US had tightened significantly. Although the benchmark 10-year bond yield had fallen, other market indicators had worsened: financial markets volatility, the interest spreads of corporate bonds and others.

These resulted in a de facto tightening of monetary policy, beyond levels judged to be appropriate. The recent Fed dovish statements might have been intended to ease these conditions, in which they have largely succeeded. 

Fear Of Failure

Global central banks now have a dilemma. The Fed Funds Rate at 5.35 per cent, for instance, implies a real policy rate of over 2.4 per cent, which is considered overly tight at this stage of the growth cycle. While wary of keeping interest rates high for too long and risking pushing economies into recession, they are equally concerned about a policy mistake of prematurely cutting rates resulting in a resurgence of inflation. 

The policy mistake of 2021 is still too searingly vivid in central banks’ memories. After spending all of 2021 considering inflation as “transitory” and delaying policy tightening, the inflationary surge post the Ukraine crisis forced all global central banks into a synchronised rate hike at an unprecedented pace.

The global economy is now at a juncture where growth momentum is clearly slowing, but inflation remains persistently sticky. From double digits in mid-2022, inflation in most developed countries has fallen to sub-3.0 per cent, but the pace of “last mile” disinflation is proving tricky, with services inflation, in particular, remaining elevated. 

Wither Fed Actions?

The key question is the appropriate long term policy interest rate: the so called “terminal” rate. How much will the Fed cut – or be able to cut – its policy rate? This is tied with the “neutral” (also called natural) interest rate – level which is neither inflationary or likely to result in recession.

This is very important for financial markets – bonds, equities and foreign exchange – given the role of expectations into transmission of policy. In the June projections, longer term projections of the FFR – beyond 2026 – was 2.8 per cent, versus the current 2 per cent inflation target. 

There are also questions about whether the 2 per cent target itself needs to be revised (up) given the ongoing reconfigurations of global supply chains making manufacturing inputs more expensive. 

How Will It Influence RBI's Decisions?

The rate actions and accompanying communication and economic projections at the September meets of the Fed and ECB, however, will provide signals on the likely paths of monetary policy over 2024 and 2025. These will be important inputs into the decisions of our own Reserve Bank's Monetary Policy Committee’s policy actions. 

The spillover of global volatility into emerging markets including India was inevitable, via multiple financial and consequently economic channels. The dominant channel of this transmission is the exchange rate, supplemented by commodity prices, especially crude oil. Consequently, there is an obvious need for India to keep a watch on what the Fed eventually decides and why.