The US Federal Reserve's monetary policy in December repeatedly suggested that the post-pandemic interest rate hike cycle, which began in early 2022 and resulted in a 525 basis point increase in the federal funds rate, may have peaked. The average prime interest rate was cut to 5.4 percent from 5.6 percent in September, according to the summary of economic forecasts. Fed Chair Jerome Powell's language was less aggressive and did not place too much emphasis on the word “hawkish.” In addition, the forecast key interest rate was cut to 4.6 percent towards the end of 2024, meaning at least three 25 basis point cuts in the next calendar.
Unsurprisingly, financial markets were euphoric over expectations of lower funding costs and increased liquidity. The yield on the U.S. dollar and U.S. Treasury bonds fell as money moved out of safe havens. A broad-based rally was seen in global stock and bond markets, with riskier assets such as emerging market currencies also rising.
However, this unbridled optimism is unwarranted and markets need to curb their optimism. First, the Summary of Economic Projections (SEP) numbers are only expectations of Federal Reserve board members and presidents and not the plans or decisions of the FOMC. Second, the Fed has left itself room to raise interest rates if necessary, stating that future rate actions will depend on incoming data and that the Fed remains committed to bringing inflation to the 2 percent target. Given the lagging effect of interest rate hikes, it is taking a pause for now, but may change its stance if necessary. Third, market participants could become too optimistic about inflation. While the core PCE index in the US fell to 3.46 percent in October from 5.09 percent a year ago, it is still far from the Fed's 2 percent target. The SEP forecasts also suggest that PCE inflation will not rise to 2 percent until 2026. Additionally, core inflation in the US is proving stubborn due to rising service sector wages. Given the ongoing geopolitical uncertainties, the risks to global inflation also remain elevated.
The other two major central banks that announced their monetary policy last week – the European Central Bank and the Bank of England – gave mixed signals. While the ECB hinted that the rate hike cycle may be over, the Bank of England remained extremely cautious about inflation, which is not yet under control. The latter pointed out that interest rates may have to remain higher for a longer period of time. The external environment for India will remain challenging in 2024 given uneven growth and inflation across advanced economies. The RBI is also likely to keep a close eye on inflation in the coming year and it might be too early to expect a reversal in the domestic interest rate cycle any time soon. Investors would be wise not to rely solely on monetary policy measures to make their investment decisions
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