With inflation still elevated and the banking sector facing a question mark, the world is looking at this week’s meeting of the Federal Reserve. But that doesn’t mean you should change your portfolio. Not yet, at least.
As someone said, “may you live in interesting times.” And we are living in interesting times in the context of interest rates. During the challenging times of Covid, central banks all over the world cut interest rates like there is no tomorrow. In the US, the Fed rate was cut to near-zero and the European Central Bank (ECB) deposit facility rate was negative. The Reserve Bank of India also cut rates, but the repo rate was reduced to a reasonable level of 4 percent, so that the rate structure was not upset.
Central Bank balance sheets all over the world ballooned, to pump in money into the financial system. The humongous amount of money was described as helicopter money, as if a helicopter was dropping relief to flood-affected people. When things normalized post-pandemic, inflation surfaced. And to combat inflation, interest rates had to be normalized from the ultra-low levels. The US Fed rate has been raised from 0 percent- 0.25 percent to 4.5 percent – 4.75 percent. The European Central Bank deposit facility rate is now up to 3 percent. RBI’s repo rate has moved up from 4 percent to 6.5 percent.
In India, the rate normalization from 4 percent to 6.5 percent has been smooth, without any systemic issues. The banking system issues in US and Europe are quite evident by now. When interest rates are raised and bond yields in the market move up, banks are sitting on unrealized losses. Any trigger that exposes the issues at any US or European bank leads to a cascading effect.
This has led to question marks on the scope for further interest rate hikes in US and Euro-zone. And that raises the interesting question: inflation is still high. Would the central banks press the brakes on rate hikes, in view of practical limitations, or press on with their fundamental duty of controlling inflation?
The US Fed is considered the bellwether central bank. Central banks all over the world look at it for clues. This is not to say whatever it does is correct or justified. In 2021, US Fed Chair Jerome Powell said inflation was “transient”, when inflation was soaring on the way up. By the time the Fed realized that inflation was not transient but well-entrenched, it was already late in initiating the rate hike cycle. Then it did, raised interest rates since March 2022, and did that aggressively.
As mentioned earlier, the issues as a consequence of the fast-paced rate hikes are surfacing now. The next meeting of the US Federal Open Market Committee (FOMC) is scheduled for March 22, 2023. A few days earlier, before the incident of Silicon Valley Bank broke out, the market was talking of a 50 basis points rate hike, which would have taken the US Fed rate to 5 percent – 5.25 percent. Now, the market is talking of a 25 basis points rate hike or a pause. One basis point is one-hundredth of a percentage point.
More than the rate action, the guidance by the Fed will be looked forward to. What are the options before it? One, it hikes the FED funds rate by 25 basis points, does not talk much about banking system issues, and states that future rate hikes will be “data-dependent”. Two, it pauses on rate hikes and state that “we remain watchful of the situation”. Three, it hikes by 25 basis points, but gives a subdued outlook on future rate hikes.
The next meeting of the RBI Monetary Policy Committee (MPC) is scheduled for April 6, 2023. RBI decisions are taken on the basis of our fundamentals e.g. inflation and not US Fed action. The Fed action is one of the relevant inputs for the deliberations in the MPC meeting. On your part, do not shuffle your portfolio just now. Just keep a watch, till we get some clarity which way things are panning out.