There is good reason for the US Fed’s rate path to be this foggy

Talk of an economic recession in rich-world countries led by the US seems to be getting stronger. As Austan Goolsbee, president of the Chicago Federal Reserve, said recently: “Some mild recession is definitely… a possibility.” The Federal Reserve system has 12 regional reserve banks. The Chicago Fed is one of them. A technical recession is a situation where the size of an economy contracts for two consecutive quarters.

The bond market until very recently seemed to be betting on a recession. The 10-year US treasury bond yield was at 4.1% as of 2 March. By 5 April, it had fallen to 3.3%. The bond yield at any point of the time is the return investors can expect if they buy the bond and hold on to it until its maturity. Treasury bonds are issued by the US government to finance its fiscal deficit.

A fall in bond yields points to the bond market betting on the Federal Open Market Committee (FOMC), the Fed’s monetary policy committee, cutting interest rates. Typically, whenever a central bank expects a recession, it cuts interest rates. The hope is that at lower rates, people would borrow and spend while companies would borrow and expand, spurring economic growth.

Since 5 April, the yield on the 10-year US treasury bond has risen to 3.6%. Is the bond market changing its mind about a recession? It’s too early to say.

Further, the expectations of lower interest rates has led to money pouring into stocks. The Dow Jones Industrial Average, the premier stock market index in the US, has risen by 5.4% during the last one month.

So, will the FOMC cut interest rates when it meets next in early May? On 8 March, Fed chairperson Jerome Powell told the Banking Committee of the US Senate: “The ultimate level of interest rates is likely to be higher than previously anticipated.”

The FOMC has raised the federal funds rate by 475 basis points since March 2022 to 4.75-5% currently. The federal funds rate is the rate at which US commercial banks borrow and lend their extra reserves to each other on an overnight basis. FOMC projections for March forecast that the federal funds rate will be in the range of 4.9-5.9% in 2023. In December, the range was 4.9-5.6%. This suggests that the Fed might raise rates further.

The Fed has raised the funds rate at a fast pace to control inflation in the US. Inflation according to the US personal consumption expenditures index (PCE), which excludes food and energy items, stood at 4.6% this February, down from 5.4% in the same month of 2022.

So, why is the Fed reluctant to cut the funds rate? It has taken a year for inflation to fall from 5.4% to 4.6%. The Fed’s target is 2%. So, clearly, the fight against inflation isn’t over. As Powell said in a recent press conference: “The process of getting inflation back down to 2% has a long way to go and is likely to be bumpy.”

Also, employment conditions in the US remain strong. Between December and March, the unemployment rate in the US varied between 3.4% and 3.6%. The last time such a low unemployment rate prevailed on a sustained basis was in 1969. This has led to wage inflation of 6.3% in January. While this is down from a high of 9.8% in June, it still is high. A high wage inflation can keep feeding into inflation as companies try to recover from consumers what they pay to their employees.

To break this cycle, the Fed needs to discourage companies from borrowing, expanding and recruiting people. The commercial and industrial lending by US banks grew by 10.1% in March. The growth was 15.1% in November. While lending growth has slowed, if wage inflation has to be controlled, it needs to slow down further.

So, there is strong reason for the Fed to continue raising its policy rate. Nonetheless, the US central bank has been known to make sudden U-turns in the past. In March, a few mid-sized American banks got into trouble. If that crisis escalates, the Fed may have to cut rates to ensure that a banking crisis doesn’t turn into an economic one.

The second reason is not that obvious. As Niels Clemen Jensen, founder and chief investment officer of Absolute Return Partners, recently wrote: “I remain convinced that central bankers may not mind inflation running ahead of targets for a while, reason being that inflation destroys debt.” If the FOMC gets its head around this idea, then it might cut interest rates and let inflation run, so as to reduce the real value of American government debt.

Now how does all this impact India? First, from December to February, goods exports to the US fell more than 6%. Second, the IT companies are already feeling the heat, with prospects for this financial year not looking so good. Third, if the Fed cuts interest rates, Indian stocks will rally. Of course, there is no way of knowing this for sure. The only way to play this is through right asset allocation, where, depending on an individual’s risk profile, holdings can be diversified across stocks, bonds, fixed deposits, gold, real estate etc. Finally, it will be interesting to see what the Reserve Bank of India (RBI) does if the US central bank chooses to raise the federal funds rate. In its last meeting, the monetary policy committee of RBI had decided to pause raising rates.

Vivek Kaul is the author of ‘Bad Money’.