What does the Fed March Rate Hike mean for India for calendar year 2023?

The March 22nd Fed meet marked the second meeting of the Federal Open Markets Committee (FOMC) for calendar year 2023. A lot had suddenly changed on the rate outlook in the US due to the banking crisis. Just about 15 days back, the markets were confident that the Fed would go for a 50 bps hike in March 2023 to control the rampant inflation in the US economy.

However, when the Fed statement was made, the rate hike was just about 25 basis points. What really changed the narrative was the banking crisis that has snowballed in the last 2 weeks in the US. First, it was Silicon Valley Bank that went bust as it witnessed a run on its deposits and huge bond losses. It was followed by Silvergate Capital and Signature Bank folding up and First Republic Bank almost on the brink. With Credit Suisse forced into a sale to UBS, the Fed realized that discretion was the better part of valour.

The Fed had 2 choices. It could either stick to its 50 bps rate hike; but that would have been too ambitious at a time when many small banks were on the brink. Going all the way down to zero rate hike would indicate that the Fed was going slow on its battle against inflation. That would send a wrong signal. Hence 25 bps rate hike was a compromise solution. Eventually, the Fed took the rates up by 25 bps to the range of 4.75% to 5.00%.

A sharp change in the CME Fedwatch probabilities

The one thing that bridges the gap between Fed policy and market expectations is the CME Fedwatch probabilities which calculates implied probabilities of rate hikes over the next few meetings. Here we look at the forthcoming 8 Fed meetings over the next 1 year.

Data source: CME Fedwatch

How do we interpret this table above and what does it tell us about what the markets are thinking about the Fed trajectory of rates?

• It is all about the collapse of mid-sized niche banks that has changed the expectations in the market. The terminal rate forecast has been cut to 5.25% from 5.75% in the February 2023 meeting. Rate cuts may almost be over in the current cycle.
   

• In fact, markets are expecting rate cuts to start as early as July 2023 and the Fed to cut rates by 100 bps by the end of 2023 and by around 200 bps from current levels by middle of 2024. That is a big shift in market interpretation.
   

• Markets are pencilling in the possibility that the banking crisis would be deeper and more intense than expected. The Fed statement has only hinted at a possible 100 bps cut in rates in the year 2024, but markets are betting on more and much quicker.

One thing that emanates is that, the Fed rates may be very close to its peak terminal rates than envisaged.

Fed statement was a pragmatic compromise

Clearly, the Fed statement for March 2023 was a pragmatic compromise and that was, perhaps the right way to do it. With the latest 25 bps rate hike, the Fed rates stand in the range of 4.75% to 5.00%. It was a compromise because the policy statement was less about inflation and more about the possible spill-over effects of the banking crisis. Fed has hit two birds with one stone through this compromise. On the one hand, it has still given the impression that Fed is in charge of the inflation situation and would still strive for 2% inflation target. However, it has also reassured depositors that their money with the banks were safe. Fed may have been silent on uninsured deposits, but this was not the forum.

However, on the topic of future rate outlook, Powell did leave an escape route for the Fed. He has underlined that the current rate hike did not factor assumptions on credit slowdown. Here is how it works. Any banking crisis makes banks less willing to lend, triggering a credit crunch in the economy. In such an eventuality, Fed may even abandon its current hawkish stance. However, that would on be done if the credit crunch was prolonged and intense. One big shift in the statement is that the Fed is no longer talking about keep rate policy separate from the banking crisis. That was impractical in the first place, since the overlaps are too deep and significant. Of course, Powell has dismissed market hints of a 100 bps rate cut in 2023, but then markets are talking about the abnormal and not about the normal.

Is this latest Fed statement positive for India?

In a sense, it is positive for Indian macroeconomic policy. Of course, the RBI is likely to stick to its stance for now and hike rates by 25 bps in its forthcoming April meeting. However, 2 of the 6 members of the MPC are already strident critics of the hawkishness of the RBI. They want less focus on inflation control and more on growth facilitation. However, for now, majority of the MPC members are still veering towards using rate hikes to control inflation expectations. The good part is that the banking crisis has had limited impact in India.

However, rate hikes have wrought their own damage by compressing corporate net margins, reducing interest coverage comfort, and Implying losses in bond portfolios. However, for now, RBI may not want to tinker with its long term perspective and may just about stick to its 25 bps rate hike in April. However, the April 2023 policy statement is likely to see a hint from the RBI that, like in the US, Indian economy was also close to its terminal peak rates of interest. That is likely to fasciate the markets, above all else.