A steep 29 per cent decline in global crude oil prices since early October 2018 and a sudden shift in the consensus view back to deflationary risks in the US economy have prompted increased expectations of an early end to the Feds rate normalisation.
And indeed, a presumed dovish stance in last weeks Congressional testimony by Fed Chief Jerome Powell has been interpreted as sign of a relapse in excess global liquidity and risk-on trade.
Consensus expectations now price in only two to three more Fed rate hikes until 2019 end in contrast with the Feds earlier guidance for four hikes to 3.25 per cent by 2019 end.
This is recreating a belief that the relapse of a weak US dollar and easy liquidity will propel portfolio flows to emerging markets, including India. We see considerable risks to this trade.
Indian markets responded with a quick bounce across equities and bonds, along with gains in rupee value against the US dollar.
But this could be a false signal, as things havent changed much for the Fed. There is little evidence from both Powells speech and US macroeconomic conditions to suggest that the Fed is deviating from its normalisation path. On the contrary, the speech sounded fairly positive, even as it balanced the future risks.
The concomitant occurrence of positive output gap (real GDP growth of 3.0-3.4 per cent compared with a potential 2 per cent), negative unemployment gap (unemployment rate of 3.7 per cent is less than the non-inflationary level of 4.6 per cent) and the decline in initial jobless claims to 40-50-year lows suggest a strong and sustainable growth traction.
Households have refrained from leveraging the wealth effect of the increase in net worth. The phenomenon of wage growth outpacing productivity gains should push up core inflation. Indeed, core PCE inflation has been moving up gradually to 2 per cent from about 1 per cent in 2016. This is higher than the long-period average of 1.7 per cent during 1997-2018. The receding fiscal impulse in 2019 will likely be counterbalanced by corporate investments and a pick-up in credit demand.
Small business surveys exude confidence not seen since mid-1980s. They demonstrate a strong intent to hire, pay more wages and increase product prices. Senior banker surveys suggest there is an increasing willingness to lend to firms and households.
In Feds own assessment, normal volatility in equity prices is unlikely to change stance. Thanks to the significant regulatory reforms since the global financial crisis of 2008, the US financial system is solid today. A study of financial vulnerabilities indicates only a moderate degree of risk across 1) leverage of financial institutions; 2) their fund mismatches; 3) debt levels of corporates and households; and 4) valuations across asset classes.
Hence, incorporating the current set of backward- and forward-looking macro indicators, our estimate for a fair value of the Fed rate is closer to 4 per cent (estimated on forward looking Taylor Rule models).
Assuming household conditions remain strong and financial conditions stable, it would be realistic to expect the Fed rate to breach 3 per cent in next 12 months. At those levels, the Fed rate will just be above the estimated neutral level of 3 per cent.
Feds normalisation has been a risk for emerging markets, as reflected in their tightening financial conditions earlier in 2018. They experienced sharp currency depreciation and policy rate hikes amid an outflow of portfolio investments and a decline in central banks forex reserves.
Financial condition indicators for Asia, ex-Japan, have worsened to levels seen in 2013, in the aftermath of the taper tantrum. The carry-trade confidence indicators have also dipped since March 2018. But notwithstanding the recent corrections in equity markets and higher interest rates, financial indicators for Asia are still significantly better than the levels seen during the global financial crisis of 2008.
Hence, from Indias standpoint, the recent gains in INR/USD and the softening in G-sec yields could reverse, precluding a full maturation of the risk-on trade. A slowdown in real GDP growth to 7.1 per cent in September quarter from a robust 8.2 per cent print in the previous quarter amid higher core inflation at 6.0 per cent-plus suggests peaking-out of near-term growth impulses. This contrasts with the strong cyclical positioning of the US economy.
Indias persistent vulnerability of its financial sector, including the recent disruptions in the NBFC sector and the ongoing RBI-GoI friction, also contrasts with the robust and comprehensive assessment of US financial system. The idea to strip off RBIs reserves to use in funding fiscal spending is fraught with risk of rising volatility, as it would impair the central banks credibility in managing stable market conditions. Such attempts should clearly be avoided to ward off adverse spillover impact of potential tightening in global financial conditions for emerging economies.
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