Thursday, 16 March 2017

Fed obliges markets, but Trump could play spoilsport

In line with market expectation the US Federal Reserve raised interest rates by 25 basis points (bps), taking the overnight fund rate to a target range of 0.75 percent to 1 percent.

What is likely to be seen as dovish by analysts is the projection of two more rate increases this year. Morgan Stanley had expected the Fed to raise rates seven times in 2017-18. Bond yields fell immediately after the Fed announcement from 2.6 percent to 2.5 percent in a sign of relief that the Fed was not as hawkish as some analysts expected. The Fed has lowered the expectation as inflation approaches its target.

In a move that would please global markets, the Federal Open Market Committee (FOMC) described job gains as solid and business investment appearing to firm up. Inflation, the statement said, is moving close to the committee’s 2 percent target. Fed had forecast inflation to reach 1.9 percent in the fourth quarter of current year and 2 percent in both 2018 and 2019.

As for unemployment, the officials projected it at 4.5 percent, the same level as in December forecast. The jobless rate was 4.7 percent in February.

Though interest rates have been increased the Fed has not shifted its estimation of US GDP growth at 2.1 percent in 2017 though it projected a minor increase from 2 percent to 2.1 percent in 2018 and kept 2019 estimates at the same level of 1.9 percent.

Nonetheless equity and oil markets moved higher after the rate increase indicating that the numbers have been well taken. The ball is now in President Donald Trump’s court as market waits to see his Congress take the responsibility for providing economic stimulus, a role that was played by the Fed for nearly a decade.

Expectations in the US markets are high that an aggressive fiscal policy will bring back growth. However, Fed’s data does not reflect the optimism – growth has been stagnant for three years.

As was the case in India post Narendra Modi’s landslide electoral win, hopes and expectations from the government are higher than the actual numbers warrant. In the United States too, sentiment surveys show that confidence is running high but this confidence is not getting transmitted to the economy.

U.S. retail sales in February 2017 grew at the slowest pace since August 2016 while oil inventory in the country continues to rise week after week.

It is perhaps due to this lack of clarity that Fed Reserve chairperson Janet Yellen ducked a question on the timeline for the Fed to shrink its massive balance sheet.

The way things stand, Trump would like to consume more resources to meet the shortfall in his revenue targets as a result of expected tax cuts. That being the case a higher fiscal deficit would push inflation higher and might prompt the Fed to speed up its rate increases.

Clearly, Trump’s behaviour in the coming months holds the key. It’s not ruled out that Morgan Stanley’s forecast for rates comes true in the medium term.

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