The US Federal Reserve adopted an affirmative position on the trajectory of monetary policy normalisation with its patience on high inflation now running out and has now started impacting growth.

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The insistence on the transient nature of high inflation has waned considerably. The advent of QE taper from November 21 is a sealed outcome and rate lift-off starting from 2022 is now an emphatic view of FOMC members.

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Federal Reserve keeps interest rates steady, aims to promote employment, and control inflation

Our reading of FOMC’s statement: 

a) The US Fed now thinks Quantitative easing (QE) as a tool to support the economy has lost is utility and hence needed to be wound back. A gradual taper will certainly begin from the next meeting in Nov’21 and will end by mid-2022, implying a monthly reduction of ~USD 20bn from the current QE of USD 120bn/month. The taper can be speeded if inflation remains elevated and jobs trajectory is better. 

b) The decision on taper will no more be incremental data-dependent as the US Fed will now look at cumulative evidence on jobs scenario till Nov’21. 

Since FOMCs believe that the recent shortfalls were caused by the spread of the Delta variant, the fact that 11 mn jobs opening far exceed the unemployment level, the labor market has effectively passed the litmus test.

The effective unemployment rate is probably much lower than the report 5.2 per cent for Aug’21 and is likely to head below the 4 per cent long-term levels in 2022. 

c) With all measures of inflation running much higher than the target of “slightly above 2%", the objective on price stability front has been met long time back. 

d) Most notably Chair Powell’s dropped his earlier insistence of the transient nature of high inflation. From the Q&A, it appeared that while the medium-term PCE inflation projections remain anchored at 2.2% (2022-2023), the scaled-up level of inflation at 4.2% and core inflation at 3.7% in 2021 reflects declining patience on inflation.   This reflects in Fed’s new assessment that supply bottlenecks, aggravated by the spread of delta variant, are more enduring than earlier thought and is hurting growth. 

e) Greater openness on the possible scenario of rate lift-off in 2022 itself. All but one member out of 18 expect one rate hike starting in 2022. The median expectation is of cumulative 7 Fed rate hikes of 25bp each till end of 2024 to 1.8%.  

This would move up the real Fed rate would from the current -4.2% to -0.25% by end of 2024. This lift-off trajectory can undergo further calibration as we move into 2022, in our view. 

f) On the possibility of balance sheet reduction, the Fed would first work out the tapering before that. Given the trajectory of past normalisation we are assuming balance sheet reduction till end of 2024 (USD 15-20bn per month) after QE ends by mid of 2022. 

g) The Fed sees no risk to US from China’s housing contagion as US banks have little exposures and US companies are in good balance sheet position aided by the large stimulus. However, there can be multiple channels of implications for the global economy.  

Key Implications:

The US Federal Reserve's new normalisation guidance is falling in line with our expectation of “uneasy taper” guided by scaled down growth outlook and scaled-up inflation projection. The declining patience with high inflation adds to the dimension that many FOMC members were articulating earlier. 

a)   Thus, we maintain our projection of US money supply (M2)/ GDP declining from 89% currently to 80% by end-2024. This should have a downside bias to Indian markets multiple. 

b)   Strong dollar view and softening commodity price outlook are maintained. FII flows should continue at moderate pace as we have seen Apr’21. Though ECB has also started debating on tapering it is expected to follow the Fed (see here).

c)   China’s housing and construction sector contagion and growth slowdown was not surprising to us, its persistence in absence of a meaningful bail-out for Evergrande debacle should fortify our UW position on metals since May-Jun 2021; we believe in a few months this will become a consensus view.

d)   Unfolding of stagflationary situation may be unrewarding for deep cyclicals

Portfolio Strategy:

Hence, our focus on domestic themes, particularly Consumption, public spending led and IT sector remains. We have been EW banks, UW commodities, and selective on Cap goods and small-mid caps.

(The author is MD & Chief – Strategist, JM Financial Institutional Securities)

(Disclaimer: The views/suggestions/advices expressed here in this article is solely by investment experts. Zee Business suggests its readers to consult with their investment advisers before making any financial decision.)