FXStreet (Delhi) – Research Team at HSBC, suggests that an uptick in inflation could convince the Fed to speed up its pace of tightening, which could act as a drag on economic activity.
Key Quotes
“In September, the median FOMC policymaker projected a rise in the federal funds rate to nearly 1.5% at the end of 2016 and to over 2.5% at the end of 2017. The real federal funds rate, according to the FOMC’s projections for core inflation, would rise from around -1.0% currently up to 0.7% at the end of 2017.
There is a risk that following this path of rate increases could slow the growth of aggregate demand in the economy by more than anticipated. The equilibrium real rate of interest appears to have declined compared to the past and may not rise very much in the near future if labour force and productivity growth remain low.
Uncertainty about the equilibrium rate of interest may lead Fed policymakers to react even more strongly to actual inflation outcomes than would otherwise be the case. Any uptick in core inflation could convince the FOMC to speed up its pace of policy tightening.
In this scenario, the lagged effects of monetary tightening could end up slowing economic activity more rapidly than expected, leading to a stop-and-go policy and increased volatility in financial markets.
Emerging markets investors have adapted to the idea of Fed lift-off at the end of this year and have moved to focus on the pace and duration of tightening. The overwhelming consensus in the market is that the Fed will revise down its dot-plot towards lower market expectations, as it has repeatedly done so throughout 2015. The improvement in EM risk appetite since October, following a dismal third quarter, rests on the idea that this is going to be the most ‘dovish’ tightening cycle ever with potential long pauses, even reversals of the hike(s).
Our base-case entails near zero US real interest rates on 10-Y Treasury for 2016, which, everything else held constant, gives us stable non-resident capital flow at around 2015 level of 1.8% of GDP, or nearly USD500bn. If we were to increase US real interest rate assumption to slightly over 1.0%, this would nearly halve EM capital flows to around USD280bn or c1.2% of GDP, the slowest capital flow since 1990. Assuming the same extent of capital outflows by residents (such as external asset acquisition and external debt repayments), this might give even deeper net negative capital flows (net of resident and non-residents).”
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