U.S. Rates May Be Heading Higher Than Expectations?

In 2022, most U.S. investors and central bankers underestimated how high inflation would climb. Now they may be underestimating how high interest rates will need to go to bring inflation down.

Although the Federal Reserve had the most aggressive credit tightening campaign in four decades, payrolls surged, retail sales jumped, and equity prices soared.  Inflation so far has been sticky and running well above the Fed’s 2% target. That’s a recipe for more rate hikes.

The risk is that tighter credit eventually catches up with the economy and triggers a recession. Investors are already upping their bets on how far the Fed will raise rates in this tightening cycle. They now see the federal funds rate climbing to 5.2% in July 2023. That compares with a perceived peak rate of 4.9% just two weeks ago in early February 2023. The central bank’s current 4.5% to 4.75% target range will not hold for long.

Source: https://www.investopedia.com

Economists are marking up their estimates of what’s known as the terminal rate — the highest point that the Fed will get to. Some have raised their forecast to 5.6% from 5.1%, citing a resilient labour market, easier financial conditions and elevated inflation.  Fed policymakers are also sounding more hawkish as well.

During their last forecasting round in December, Fed policymakers pencilled in a peak rate of 5.1% for 2023. Former International Monetary Fund chief economist Ken Rogoff won’t be surprised if rates end up at 6% to bring down inflation. 

The latest problem is not inflation but bank failures—SVB and two others for now. The Fed is constrained from raising rates which could lead to more failures (if they do) and a contagion or an Armageddon to follow. The joint statement by Treasury, Federal Reserve and FDIC on March 12 may allay some fears. 

What’s that got to do with Malaysia? Our OPR is currently at 2.75%. If the differential between OPR and the Fed Funds rate keeps widening, the impact is on currency and inflation. The ringgit will depreciate significantly to be close to RM4.60 to the dollar while inflation may double from 4%. Why? For us, it is imported inflation with food imports alone amounting to RM60 billion annually. Then there is intermediate goods and others. For currency depreciation, it is a whole host of factors including interest rate differential, inflation (comparisons), net outflow of funds, trade surplus/deficit and speculation by professional traders. If the Fed were to defer a rate hike because of the current banking situation we are in a better position to decide on our OPR rise or otherwise. Meanwhile its best BNM issue a statement that our banks are on solid footing and all depositors are assured of their funds placed with banks.

Reference:

US rates may be heading higher than Wall Street or the Fed think, Rich Miller, Bloomberg, www.theedgemarkets.com, 16 Feb 2023