Shifting global expectations

Markets are anticipating less tightening by central banks

A relatively lower inflation reading and the interpretation of a recent statement by US Federal Reserve Chairman Jerome Powell have had market participants believing that the US central banks will not tighten monetary policy to the extent previously anticipated. This has increased risk appetite in global financial markets. Stocks have rallied in most markets and funds have started flowing back into emerging market countries. Mr Powell in his remarks after the July meeting of the Federal Open Market Committee, which decided to increase the policy rate by 75 basis points, said that the Fed will now make decisions meeting-by-meeting and will not provide guidance as it did “on the way to neutral”. This was interpreted by markets as a signal to less tightening. The US retail inflation rate for July was at 8.5 per cent, compared to 9.1 per cent in June. 

Commodity prices have come down in recent months because a slowdown in the global economy would affect demand. The Chinese central bank surprised global markets this week by cutting interest rates, which immediately resulted in a fall in crude oil prices. A sharp slowdown in the world’s second-largest economy would affect demand and prices. China’s real estate sector, which has been a major driver of growth, is visibly in trouble and lower activity in this area alone will depress global demand for commodities such as steel and copper. The Bloomberg Commodity Index has fallen over 8 per cent since the beginning of June. As financial markets tend to price the future in advance, investors are expecting inflation to moderate quickly, which would lead to less tightening by central banks.
 

Although prices have come down in recent months, the commodity index is still about 30 per cent higher compared to the level last year. There are several other risks worth highlighting, which could affect expectations and outcomes in the coming months. First, despite the commodity price correction, the inflation rate in the US is still significantly higher than the Fed’s target of 2 per cent. Given the strength of the US labour market, it is likely that the rate may not come close to the target soon. However, it’s likely that the quantum of rate hikes will moderate because of front-loading. The inflation rate in the UK, meanwhile, has gone into double digits for the first time in four decades.  Second, the Ukraine war, which pushed up commodity prices early this year, is still continuing with no real clarity on the endgame. Further disruption in gas supply to Europe, for instance, could again push up energy prices significantly. Third, the unease in Taiwan Strait could severely affect global supply chains. It is not clear how effectively markets can account for such risks.

The return of risk appetite in global markets has also resulted in fresh buying by foreign portfolio investors in India. Given the expansion in the current account deficit, this would help the Reserve Bank of India (RBI) in managing currency. In terms of monetary policy, since the RBI has also front-loaded the rate response, the quantum of rate hikes could be lower in the coming meetings. However, this would not mean that the central bank will settle for lower interest rates and tolerate higher inflation. It may be a bit early to significantly revise terminal policy rate forecasts, both in the US and India.