Uncertainty persists: Are the Fed and the markets on parallel tracks?

Time and again, with a greater amount of accuracy and consistency, the data flows from the US present the picture of an economy that is rapidly transforming after the pandemic, both in terms of the prospects of growth and the pace of inflation. While the Fed is quite happy about the explosion of growth, on inflation it has maintained that it is transient or transitory. It may be short lived and therefore, it may not require any specific policy prescriptions as such.

The Fed has also been categorical in its statements on the easy money policy and have reaffirmed the commitment to asset purchases and release of liquidity to support the markets. But what has made many think is that on the major macro variables, if it is an expansionary phase that the US has entered, then policy reversals must happen sooner than later. But why then there are no clear indications of a likely policy shift.

In the recently concluded FOMC meeting, the potential time for the first hike in rates has been fixed for 2023 instead of 2024 which was decided earlier. In fact, some of the members of the policy board were of the view that the first hike could be as early as in 2022. This contains a broad indication that rates could start moving up earlier than expected and that the markets should be prepared for that. If one may recall, there was a statement from the treasury secretary herself that higher interest rates are good for the US economy.

There were also statements from lesser-known Fed officials about the need to change track in case of higher price levels. In addition to all this, there were prominent reports which said that the Fed is preparing the markets gradually for a tapering of the liquidity support over time.

Despite all this, there is still a veil of uncertainty on the next interest rate move in the US and the timing of it. It is interesting to see that the ten-year treasury which was just a stone’s throw away from the 2% mark has slumped to 1.45%/ Every time it rises to 1.50%, some invisible factor pulls it down to 1.45% mark again. That could also be reflective of the thinking that there is still more time before the Fed policy will start getting reversed.

But the crux of the matter is that the Fed should not suddenly change the tone of the conversation and act swiftly after a prolonged period of policy suspense. If it actually happens it may have consequences for a lot of things.

Tapering shrinks, the effective liquidity available to the markets. A part of the rise in asset prices apart from the market premium and asset specific factors, is based on the liquidity factor. Therefore, the first casualty will be the asset prices and a moderation in these prices can be expected. The rise in the currency yield for the US dollar will permit it to remain strong against other currency majors and more so against the emerging market currencies.

It is the asset movements that determine currency movements all the while. Emerging market currencies may not be spared this time too as fund flows to the US and Europe could be stronger than earlier. These are some of the lessons that could be safely drawn from the last time we had the tapering of liquidity. Stronger dollar, weaker commodity prices and relatively cheaper currencies could redefine the investment landscape over time.

One thing that we could draw some comfort from is that the Fed may start preparing the markets more actively before any action and that in the change-over from the current circumstances let us hope that the same may be better planned. It means that the markets and the Fed would be moving on parallel tracks though the pace may be obviously different. At the same time, it is important to be diligent about it so that one does not fall prey to the consequences of any policy procrastination by the Fed.

(By Dr Joseph Thomas, Head of Research, Emkay Wealth Management. Views are his own)