Fed Rate Hike

This 25 bps could just be the beginning in a series of hikes

As the 2-day meet of the Federal Reserve concluded on Wednesday, the rate hike of 25 basis points was almost a fait accompli. Analysts and economists had long seen this coming. What was more significant was that this was Janet Yellen’s last Fed policy announcement as the next policy will be handled by Jerome Powell.  This marks the 5th round of rate hikes since December 2015 and the Fed rates have moved from 0-0.25% to 1.25-1.50% in the last 2 years. What were the triggers and what are the larger implications?

Grand economic data

US economic data has been flattering to say the least. Inflation finally appears to be getting tantalizingly close to the 2% mark. Although it is still short of that mark, it is expected that higher gasoline prices should do the trick. Labor market is at a 17-year peak with jobless rate down to just 4.1%. This is likely to fall below 4% in 2018. But the big factor has been growth projections. The Fed estimates that the US GDP growth for 2018 could end up at 2.5%, nearly 40 basis points higher than the original estimates. Of course, Trump is expecting GDP growth to touch 4% next year although there are not many buyers for that line of argument. What this means is that the level of consumption and spending is likely to reach a new plane in the coming months, making a very strong case for a rate hike, now and in 2018 too.

The $1.5 trillion tax largesse!

Another strong reason for this rate hike was that the Fed may be looking at neutralizing some of the impact of the tax largesse. The massive tax cuts that have already been cleared in the Senate are likely to reduce tax costs by nearly $1.5 trillion. While corporate will see huge tax cuts, individuals will get massive tax deferments. Either ways, it is likely to have a huge salutary impact on spending and consumption. Now, that is going to be inflationary and any spike in inflation will be something the Fed will not be comfortable with. It also opens the doors for more aggressive rate hikes in 2018; 4 instead of 3.

Implications for other economies

If the reaction from the PBOC (hiking short-term rates) is any indication, then many more central banks could now shift to a more hawkish approach. That could be the best way to avoid monetary divergence and the resultant volatility in markets. The RBI has already indicated that any rate cuts for now may be ruled out. Remember, the RBI has continued to maintain its stance at neutral since February. That means; the RBI may not really hesitate to hike rates if the situation actually warranted. If the US Fed goes for 4 rate hikes instead of 3 in 2018, then the RBI may have a tough time stemming portfolio outflows. Then a rate hike by the RBI may not really be too far away! ©

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