In 2020, COVID 19 was the elephant in the room, with its impact being felt across the globe on life and the economy. While the first part of 2021 was about stepping outside homes and starting to live with COVID-19, inflation is the new elephant in the latter part of 2021 till today.
To jump-start, the battered economy, governments and central banks across the globe resorted to ultra-loose fiscal and monetary policy. Although these policies helped restart economic activity, the pent-up demand and supply chain issues led to skyrocketing inflation.
The Russia-Ukraine conflict has only added to the woes, as commodity shortages have pushed the prices even further. Because of this, the inflation in the US has been reaching levels last seen 40yrs ago. Last week the inflation number for May 2022 came in higher (8.6%) than expected (8.3%)
Did the market price in the rate hike?
Drawing from the last FOMC meet (4th May) coupled with the expectation of inflation peaking out, the markets were expecting a 50 bps hike, but the May 2022 inflation numbers made them re-assess their rate hike expectations.
Ahead of the policy meet, the broader markets reacted negatively, with S&P 500 and Nasdaq 100 shedding ~4% in a single day (13th June, 2022). Even the 10 years US treasury yields rose in cohesion by about 35 bps and touched the 3.5% levels.
Addressing the issue?
The sticky inflation has resulted from the mismatch in demand and supply. The Fed explicitly mentioned that ‘supply-side constraints have been larger and longer than anticipated’. One may read it as it being beyond their control, and hence they would look to curb the demand to restore the balance.
Since the beginning of 2022, Fed has been trying to reduce the money supply by going for aggressive rate hikes. Continuing on the expected path, the Federal Reserve decided to raise the interest rate by 75 bps taking the Fed Funds rate in the range of 1.5%-1.75%. The 75bps rate hike is the highest since 1994.
Despite a hawkish move by the FED, the S&P 500 and Nasdaq 100 advanced by 1.4% and ~3% respectively even yield of 10 year US treasury softened by 6 bps to close at 3.44%.
Taking cues from the FOMC statement, we expect aggressive rate hikes going forward to ease inflationary pressures. However, chairman J. Powell also noted that he does not expect a 75 bps rate hike to be a common thing going ahead.
The FED members expect rate hikes to the tune of 175 bps during the remaining of 2022. One way to look at this as 75 bps hike in July followed by a 50 bps and 2 X 25 bps in the remaining three meetings. It will be prudent to acknowledge that the rapidly evolving situation will guide the actions of FOMC and shall be sensitive to new realities.
Author – Zain Iqbal, Research Analyst, Passive Funds
Co- author – Anuj Desai, Research Analyst, Passive Funds
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