US Fed rate hike might come sooner than expected; here’s how it will impact India, decodes Dhananjay Sinha of JM Financial

More than the US Fed’s decision to initiate the USD 15bn tapers for November-December 2021 what was impactful for the market was the reiteration that high inflation will still be transient, despite the overwhelming tone of uncertainty over its persistence.

Following the announcement, the US yield curve has flattened a bit with 10-year declining by 10bp to 1.53%. But the US dollar continued to strengthen with the dollar index DXY at 94.5.

It appears that the bond market was pricing in a more hawkish assessment on inflation and larger than USD 15bn monthly taper, which had seen US 10-Year rising to a high of 1.7% in Oct’21.

The US Fed's understatement of inflation and a less aggressive taper have ensured that the equity market's anxiety is tempered, thereby avoiding the taper tantrum.  

However, the trajectory of the Fed’s normalization can strengthen after December 2021 for several reasons, decodes Dhananjay Sinha, Managing Director & Chief – Strategist, JM Financial Institutional Securities Ltd -

First, after having been surprised by higher-than-expected inflation over the past 6 months there is now an acceptance that a positive supply response to compensate for the robust consumption demand will emerge only in the second half of 2022, thereby putting at risk the projected inflation of 2.3% by the end of 2022.

With the structural component of core PCE inflation, estimated at 2.4% and actual level of 3.6% in Sep’21, averaging 120bp is higher than the 2% inflation target in 1H2021, Fed’s inflation target has been fulfilled long back.

Sustaining higher than 2% inflation for another 12 months (till Sep’22) will be untenable as it would trigger a wage-price spiral. Thus, within Fed’s own assessment there is a case for faster normalisation.

Second, Fed’s emphatic reiteration that the labor market is strongly indicating that the objective of maximum employment is also mostly met. The more stringent benchmark of interest rate lift-off is dependent on the fulfillment of the remaining unemployment gap.

The labor force participation rate (LPR) has improved modestly to 61.6% in Sep’21 from the pandemic low of 60.1% and is still lower than the pre-COVID 19 levels of 63.25%.

Again, there are still 7.4 million unemployed individuals. These are seen as contrasting variables against the steep decline in the unemployment rate at 4.8% (Sep’21); the steepest post-crisis improvement in 80 years.  

Thus, there is an unusual situation of simultaneous labor market slack and extreme tightness. Fed’s expectation is that as vaccination drive gains coverage and fears subside, labor supply will improve, thereby easing both wage pressure and supply bottlenecks.

But there could be significant judgment errors here.

For instance, it is unclear if the lower LPR entirely represents labor market slack given the structural decline from 66% since 2008; a number of hypotheses are claiming permanent exit of employees from the labor force.

This could imply that the gap between the number of job openings at 10.6 million and far lesser unemployed people at 7.4 million can persist for a long time.

In addition, the Fed’s view that current high inflation is outside the ambit of monetary policy management underplays the lingering impact of earlier large fiscal stimulus on household savings, continued strength in total employee compensation (wages and salary), which is already 8% higher than the pre-covid level and the wealth effect which has risen exponentially.

The rapid and ubiquitous surge in asset prices resulting in net worth/personal disposable income rising to 8 times and for the bottom 50 percentile rising by 67% from the pre-pandemic level to USD3tn can potentially imply that the job acceptance ratio will improve very gradually. High savings and wealth effects can create disincentives to work.  

Thirdly, over the past six months, the pricing power of US firms has improved significantly with 64% of surveyed firms expressing the ability to pass on the high cost of labor and raw material to product prices; the current levels are highest since 1980.

Hence, the comfort expressed by the Fed that they do not see the cost inflation translating into spiraling output prices may be ephemeral.

Our forward-looking model estimate for fed rate fair value suggests that while the Fed has already lagged on initiating the taper by a few months, multiple indicators now suggest that the margin towards meeting the stringent rate lift-off criteria is fast narrowing.

The net decline in unemployed at 250-260 million a month (Oct’21) implies that by Dec’2021 the unemployment rate (UR) can easily decline to the estimated neutral rate of unemployment for 2021 at 4.45% from the current 4.8%.

And an extended trajectory can imply UR declining below the estimated neutral rate for 2022 at 4.41% in the first quarter itself.

The 4% rise in the total number of hours worked per month since Feb’21 to 17.2 trillion in Sep’21 is fairly strong and is 2.8% lesser than the pre-pandemic levels.

Assuming the same monthly pace in the coming months, the pre-pandemic level can be attained in 4-5 months. This rough calculation also indicates that non-farm payroll of 147 million can match the per-pandemic level of 152 million within a few months.

The current combination of the unemployment rate (UR) and the number of hours worked is similar to 2017-18 which was preceded by the first 25bp rate hike in Dec’2016 and was followed by 8 hikes till 2019.

Thus, in the most likely scenario, one can expect the tightness in the US labor market to continue despite the expected gradual improvement in labor supplies.

The backlog of cost pressures, including raw materials, imported products, improving pricing power of firms and lagged indexation of wages could mean continued inflationary pressures.

There could be elements of deflationary factors as well, including easing of energy prices in the spring season; also, the steep rise in metals prices can also ease after the exponential rise due to competitive imports.

The dilemma for the US Fed of the potential stagflationary impact of high inflation, recently aggravated by the rise in energy prices impacting growth is a real one.

It is also shared by the Bank of England, which refrained from initiating a rate hike this week, despite the series of hawkish views from the Governor over the past couple of months and who hinted that the bank will need to act amid high inflation of above 3% and core inflation at 2.9%.

The choice is between letting adverse stagflationary conditions pan out with central banks remaining passive or them being more proactive.

The overarching impression coming out of the US Fed and also BoE is high inflation will automatically subside due to adjustments on both demand and supply sides and hence, they are not behind the curve.

However, multiple trends suggest that the US (and also the UK) could be meeting the more stringent conditions for rate lift-off much sooner than expected.

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Thus, the modest tapers in Nov-Dec’21 could well be the first step towards an accelerated normalisation as evidence favoring rate hikes start to emerge in the first quarter of 2022.

The current dithery is probably attributable to the adverse growth impact of sudden spikes up in energy prices, but that could fade out in a few months.

Impact on India:

From India’s standpoint the combination of a strong dollar, higher yields, and quicker normalisation could impact portfolio flows into India; FII flows (debt+ Equities) have been very sporadic since Mar’21 after a monthly average of USD 3bn during Jun’20-Mar’21.

India’s valuations are second richest after the US in our global comparative analysis and are strongly correlated with retail (and domestic) participation in equities.  

This is explained by surplus banking sector liquidity due to the accommodative monetary stance, aggressive forex reserve build-up by the RBI, and low credit growth.

We expect a decline in RBI’s forex reserve in response to the onset of US tapering and lower FII flows, widening current account deficit, RBI’s normalisation (stoppage of GSAP purchases), and pick in domestic credit growth will collectively reduce surplus domestic liquidity in the coming months, thereby leading to valuation normalisation, especially in the small and mid-cap space.  

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