Finally, the US Fed's QE taper has arrived. What will change now? An analysis.
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US Federal Reserve officially commences QE tapering
- The story: What roiled the emerging markets in 2013, is again here. This time it is with prior notice, and hence is not causing turbulence. The much-feared taper by the Federal Reserve will now lead to reduction in Fed's asset purchases by $15 billion a month in November and December 2021. Since markets were well-informed about this taper, they took the news in their stride. Experts now await the actual "US Fed dot plot" on interest rates.
- What is the "Fed dot plot": The dot plot is the expected trajectory of interest rate hikes proposed by US Fed members in graphical form.
- The US Federal Reserve’s Federal Open Market Committee (FOMC) releases its dot plot along with its projections on other major economic indicators like GDP, inflation, etc.
- Eighteen members that include the Federal Reserve Governors and Presidents of the regional banks participate in this. Every member of the committee offers their prediction on where the policy rate should be over the next three years. Each member’s interest rate forecast is then plotted on a graph in the form of a dot plot.
- The policy rate in the US is currently in the 0-0.25 per cent range. So, if FOMC member A predicts that the rates can go up to the range of 0.5-0.75 per cent in 2022, then his forecast will be taken as 0.625 — the median value of the 0.5-0.75 range.
- The median value of each member’s predicted range is plotted accordingly, to arrive at a graph which will effectively have 18 dots for each year representing each member’s rate forecast. Who has predicted what is kept confidential. The dot plot was introduced by the Fed in 2012. It is published four times a year (once a quarter) in March, June, September and December.
- Importance of it: Financial markets dislike surprises especially of the negative kind. The Fed’s dot plot tells the market in advance where interest rates could be heading in future. Though the dot plot may change with each Fed meeting, markets seem to prefer having something to work with rather than groping in the dark. Today the dot plot is particularly important because the US central bank has been maintaining its interest rates near zero for a prolonged period. The dot plot will give a hint to the markets on when the rate hike cycle may begin and, more importantly, what could be the possible pace of increases in rates.
- How does it impact Indian markets: Record low interest rates in markets like the US have played a key role in keeping the global stock market rally going. Indian stock markets are at all-time highs. The US stimulus taper is already here. With no known uncertainty in the vicinity for the market, interest rate hikes from the US will be one event that will now be keenly watched by the market.
- The dot plot released in June 2021 had shown 12 members out of 18 predicting that rates would remain at the current levels of 0-0.25 per cent. But in September, this had come down to nine indicating that the first-rate hike is possible in 2022 itself. The September dot plot also showed that there could be three rate hikes in 2023. The dot plot that will be released in December will need a close watch.
- If it indicates more than one rate hike in 2022 or more than three rate hikes in 2023, then that could impact stock and bond prices.
- Investors should be aware that the predictions in the dot plot need not come good and can change based on developments in the US economy.
- Dot plot technical: Dot plots are similar to bar graphs or line graphs, being used for data visualization. These types of charts are used to graphically depict certain data trends or groupings. The Cleveland and Wilkinson dot plots are the two key types of dot plots. Both utilize dots, however, there are key differences, where Cleveland is akin to a bar graph and Wilkinson is more like a histogram.
- Interest rates and stock markets: When the Federal Open Market Committee (FOMC) changes the interest rate, it impacts both the economy and the stock markets because borrowing becomes either more or less expensive for individuals and businesses. Any impact on the stock market to a change in the interest rate changes is generally experienced immediately, while, for the rest of the economy, it may take about a year to see any widespread impact. Higher interest rates tend to negatively affect earnings and stock prices (with the exception of the financial sector).
- EXAM QUESTIONS: (1) Explain the Fed Dot Plot concept. How will it influence Indian investors? (2) What are the ways the global movement in interest rates affects stock prices in India? Explain.
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