Fed's rate cut disappoints markets, sticky inflation adds to global woes

FOMC projections, dollar surge, and policy uncertainties pressure emerging markets

Adjusting to changing policy realities is often difficult for financial markets. On Wednesday, the Federal Open Market Committee (FOMC) of the United States (US) Federal Reserve reduced the target range for the federal funds rate by 25 basis points, as was widely expected by financial markets. However, both the stock and bond markets sold off. The S&P 500 dropped about 3 per cent, while the yield on 10-year US government bonds increased by about 13 basis points to top 4.5 per cent, the highest level in several months. Bond prices and yields are inversely related. The benchmark BSE Sensex in India sold off 1.2 per cent on Thursday. The elementary reason for this broad selloff in financial markets was the revised projections of the FOMC. It showed that the committee expected to reduce the federal funds rate only by 50 basis points in 2025, compared to the September projection of a full percentage point.

 

The reason for this shift is sticky inflation. Although the inflation rate has come down significantly from the highs of 2022, it is still above the Fed’s medium-term target of 2 per cent. According to the revised projections, the inflation rate is likely to be 40 basis points higher in 2025 at 2.5 per cent as against the September projection. The projection for core inflation has also been revised upwards. On the positive side, FOMC members revised growth and employment projections favourably. However, financial markets were betting on deeper rate cuts in 2025, which are unlikely to materialise now. Aside from sticky inflation outcomes, financial markets are also worried about the uncertain prospects of the second Donald Trump administration. Mr Trump, for instance, wants to increase import tariffs across the board. He also intends to impose steeper tariffs on select countries such as China.

 

Although actual action would be keenly watched across the world, from the Fed’s perspective such actions would inevitably push up prices for American consumers and reflect in higher inflation rates. Although the impact of tariffs on inflation may diminish over time, depending on the extent of the increase, it could considerably complicate the Fed’s tasks in the interim. Such changes will also increase volatility in global financial markets. Comparatively high interest rates will increase capital flow to the US and strengthen the dollar, which will put pressure on other currencies, particularly in emerging markets. The dollar index moved to a two-year high after the Fed’s decision. Consequently, besides the fall in equity markets, the rupee on Thursday breached the psychological mark of ~85 against the dollar. The rupee has been relatively stable, depreciating by just over 2 per cent since the beginning of the year, despite significant selling by foreign portfolio investors in recent months, mainly due to heavy intervention by the Reserve Bank of India (RBI) in the currency market. The RBI’s foreign-exchange reserves have fallen by about $50 billion since September, though part of it may be because of a revaluation of assets.

 

Policy possibilities in the US suggest there will be pressure on the rupee, at least in the short run. The RBI would thus do well not to burn reserves excessively to defend the currency. In fact, the rupee is overvalued in real terms and needs to adjust. Further, if the currencies of peer countries depreciate because of a strong dollar, a relatively strong rupee will affect the competitiveness of India’s tradable sectors, which must be avoided. However, the expected weakness in the currency will need to be reflected in the RBI’s inflation projections and play a role in the Monetary Policy Committee’s deliberations. Clarity in terms of policies in the US should emerge in the coming few months.