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Monday, October 26, 2020

Explained: Reading the Federal Reserve’s guidance

To stimulate the US economy, Federal Reserve has indicated that benchmark interest rates would remain near zero at least until 2023. What is the background of its guidance, and the implications for India?

Written by Anil Sasi | New Delhi | Updated: September 20, 2020 10:22:08 am
Federal Reserve Chairman Jerome Powell waits for a question from a reporter at a news conference in Washington. (AP Photo: Alex Brandon, File)

The US Federal Reserve has reaffirmed plans to leave its benchmark interest rates pinned near zero through at least 2023 and of being accommodative of periods of higher inflation, in what is seen as guidance from the central bank as it moves from the task of stabilising financial markets to stimulating economic growth.

In the September policy statement and economic projections released on Wednesday, Fed chairman Jerome Powell and his colleagues signalled their intention to be extraordinarily patient as they try to rekindle the US economy in the months ahead.

The Fed’s policy rate-setting Federal Open Market Committee (FOMC) said in a statement that the panel “expects it will be appropriate to maintain this target range until labour market conditions have reached levels consistent with the committee’s assessments of maximum employment and inflation has risen to 2 per cent and is on track to moderately exceed 2 per cent for some time”.

What is the crux of the new guidance?

The new guidance builds on a monetary policy shift that was first signalled by the Fed in June, which is aimed at neutralising years of weak inflation and enabling the American economy to counter the pandemic-induced labour market sluggishness.

The Fed also used the policy statement to signal a shift from stabilising financial markets to stimulating the economy, saying it would keep its current government bond-buying at least at the current pace of $120 billion per month, in part to ensure “accommodative” financial conditions in the future.

The virus “is causing tremendous human and economic hardship”, and the Fed is “committed to using its full range of tools to support the US economy in this challenging time”, the FOMC said. New economic projections released with the policy statement showed interest rates on hold through at least 2023, with inflation never expected to cross 2 per cent during this period.

“Effectively what we are saying is that rates will remain highly accommodative until the economy is far along in its recovery,” Reuters quoted Fed Chair Jerome Powell as saying. “That should be a very powerful statement in supporting economic activity” and returning inflation to the Fed’s 2 per cent goal faster, Powell said, adding that he thinks the forward guidance would be “durable”. The pace of the recovery is expected to slow, requiring continued support from the Fed and further government spending, he said.

Following the policy announcement, the dollar moved up against a basket of major trading partner currencies.

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Does this change the policy stance?

The Fed’s stance and the FOMC action builds on policy guidance and projections made three months ago. At their June meeting, all 17 Fed policy-making representatives projected a near zero federal funds rate — the key rate the Fed targets while implementing its monetary policy — for this year and the next.

“We’re not thinking about raising rates, we’re not even thinking about thinking about raising rates,” Powell was quoted as having told reporters following the June meeting, a maxim he has since used repeatedly.

The Fed “is both confident and committed and determined” to modestly overshoot the 2 per cent inflation — even though it would take time, Powell said. Fresh projections say the US economy could contract 3.7 per cent this year, far less than the 6.5 per cent contraction forecast in June; unemployment, which was at 8.4 per cent in August, is now seen improving to 7.6 per cent by the end of the year. All 17 Fed policymakers saw interest rates staying where they are through 2022, with four projecting the need for a rate hike in 2023.

What does all this mean?

In resolving to keep rates low until, or even after, inflation tips over the 2 per cent target, the Fed has committed itself to higher GDP and job growth, announced late last month after a nearly two-year review. The Fed held rates near zero for seven years during and after the 2008 financial crisis, before raising them in December 2015. In the last 10 years, it took more than three years for inflation-adjusted GDP to rise back to the level that prevailed before the global financial crisis.

How does the Federal Reserve affect inflation and employment?

Like other central banks such as the Reserve Bank of India, as the US Fed conducts monetary policy, it influences employment and inflation primarily by using policy tools to control the availability and cost of credit in the economy. The Fed’s primary tool of monetary policy is the federal funds rate, changes in which influence other interest rates — which in turn influence borrowing costs for households and businesses as well as broader financial conditions.

For example, when interest rates fall, it is cheaper to borrow, so households are more willing to buy goods and services, and businesses can expand by purchasing property and equipment. They can also hire more workers, influencing overall employment. The stronger demand for goods and services may push up wages and other costs, impacting inflation.

During downturns, the Fed may prune the federal funds rate to its lower bound near zero. If additional support is warranted, it can use other tools to influence financial conditions. Even though the linkages of monetary policy to inflation and employment are not direct or immediate, monetary policy is a key factor.

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What will be the impact on emerging market economies, including India?

Theoretically, a signal to maintain lower rates in the US should be positive for emerging market economies (EMEs), especially from a debt market perspective. Emerging economies such as India tend to have higher inflation and higher interest rates than in developed countries. As a result, FIIs would want to borrow in the US at low interest rates in dollar terms, and invest that money in bonds of countries such as India in rupee terms to earn a higher rate of interest.

When the Fed keeps its interest rates low, the difference between the interest rates of the two countries increases, thus making countries such as India more attractive for the currency carry trade.

A lower rate signal by the Fed would also mean a greater impetus to growth in the US, which could be positive news for global growth. But equally, this could translate into more equity investments in the US, and temper investor enthusiasm for emerging market economies.

What has been RBI’s stance on growth and inflation?

While the RBI’s Monetary Policy Committee decided to keep the policy rates unchanged in the meeting held earlier this month, Governor Shaktikata Das has said that it is important to keep the powder dry and to use it judiciously. He also said that given the uncertain inflation outlook, it is important to see the momentum in inflation, which is also dependent on effective supply-side measures.

The problem for RBI is the effectiveness of its monetary policy signal. It has cut the repo rate by 250 basis points from 6.5 per cent to 4 per cent in the 17-month period from February 2019 to June 2020, but existing borrowers have gained very little. Data show that the weighted average lending rates on outstanding rupee loans has come down by only 53 bps, almost a fifth of the cut in the policy repo rate.

The result is that even though the policy signal has been in favour of a sharp reduction in interest rates, practically all existing borrowers continue to pay a higher rate on their borrowings, thereby limiting the upside of the RBI’s policy guidance.

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Meanwhile, retail inflation, while easing slightly in August as food inflation cooled, continues to remain above the upper end of RBI’s medium-term target for the fifth straight month. The concern is this will result in inflationary expectations inching up, which could put further upward pressure on the actual inflation trajectory. With elevated inflation in the near term, there is reduced room for policy easing, at least until the RBI’s December bi-monthly policy review.

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