Fed's future path: Donald Trump's election victory increases uncertainty

Donald Trump’s decisive victory in the US presidential election has increased uncertainty regarding the direction the Federal Reserve would take, with implications for the global economy. As expected, the Federal Open Market Committee (FOMC) of the Fed decided to reduce the federal funds rate by 25 basis points last week. The US central bank started reducing rates in September with a 50 basis point cut. It had raised the policy interest rate to the highest level in decades in response to near double-digit inflation rates in 2022. Although the inflation rate moderated significantly in recent months, it remains above the medium-term target of 2 per cent. Nonetheless, the Fed started reducing the policy interest rate with the expectation that the inflation rate would soon align with the target. 

According to the projection released after the September FOMC meeting, the central bank was expected to cut the policy interest rate in its December meeting as well, followed by a one percentage point reduction in 2025. While the extent of the rate cut was always debatable — some economists argued that the post-pandemic natural rate has increased considerably — more doubts have resurfaced following Mr Trump’s victory. Some market participants now believe the Fed might skip the December rate cut. It is worth noting that while the Fed has reduced policy interest rates by 75 basis points since mid-September, the yield on 10-year US government bonds has increased by nearly 70 basis points during the same period. This is not usually how markets behave. Following Mr Trump’s victory, while stock prices advanced, bonds were under pressure, reflecting how markets would be affected by his policies. Among other things, he intends to sharply increase tariffs, particularly on goods coming from China, and reduce taxes. Higher tariffs and tax cuts will benefit American companies but will increase inflation and the Budget deficit. This explains the different positions of the debt and equity markets. 

It remains to be seen how the Fed positions itself with possible changes in fiscal policy and other factors affecting inflation outcomes. After last week’s meeting, Fed Chairman Jerome Powell argued that fiscal policy changes took time and had to be approved by Congress, indicating that the Fed might not immediately start factoring in potential changes. Although the Fed may want to wait and watch, financial markets have started adjusting, which is being reflected in the debt market. In any case, it is reasonably safe to argue that the terminal rate would be higher than recent projections. 

Besides, the US Budget deficit has increased structurally. According to the recent long-run projections by the Congressional Budget Office, the deficit is likely to average 6.7 per cent of gross domestic product over the next 30 years, which will be about 3 percentage points higher than the past 50 years’ average. Further expansion will mean more savings will be preempted by the US, which could tighten global financial conditions. This, along with higher inflation and relatively high policy rates, will further increase the cost of money. Since US treasuries are seen as the safest financial instrument in the world, money will flow to the US, strengthening the dollar. This would result in more currency volatility in the rest of the world, including India. As things stand, India is well positioned to withstand short-term volatility. However, structural changes in the US and global financial markets may require policy adjustment in India. Policymakers will need to be alert and minimise friction during such adjustment.