The Fed has spoken
Talks of a possible interest rate hike in the US has gained further momentum in January. The Federal Open Market Committee (FOMC) meeting which was held between 25 and 26 January saw the US central bank has explicitly indicated their intention to raise the benchmark rate. In its communique, it states that “…the Committee expects it will soon be appropriate to raise the target range for the federal fund rate”. This simply means the Fed will begin its monetary tightening cycle as soon as in the March meeting. Based on the probability of interest rate futures, the derivative market players have placed 100% chance that the monetary tightening will happen during that month. As in the past, news over possible higher rates would wreak havoc on the financial markets. True enough, major equity indices such as the US S&P 500 and NASDAQ have declined by 8.73 percent and 13.44 percent from the start of the year respectively. Similarly, Japan’s Nikkei 225 and Germany’s Dax index dropped 2.96 percent and 9.10 percent from early January and our own FBMKLCI index declined by 3.86 percent.
Following such negativities, it raises an important question. Does a higher interest rate is bad for the economy? Understandably, when the central bank decided to increase the policy rate, it is tantamount to a higher discount rate, a rate that is used to compute the fair value of a stock price. The general rule is that the higher the discount rate, the lower the fair value and vice versa. This could be the simple logic on why the equities market took a serious beating presently. Be that as it may, monetary tightening would normally be associated with persistent economic recovery after the central bank has prescribed an accommodative monetary stance to support the economy during a recession. Therefore, removing the policy support would simply mean cutting down the amount of “medication” that is used to heal the economy.
In that sense, the economy is gaining momentum. As a matter of fact, the quit rate, a rate that shows voluntary resignation among employees, has been rising at a fast clip to 3.00 percent as of November 2021. Compared to 2.12 percent which is the 2020 whole year average. This indicates that the labours in the US have been bold enough to quit their jobs and search for another as they have become more confident to secure new employment. Such observation is very much in line with the progressive declines in the unemployment rate to 3.90 percent during the month of December 2021 from as high as 14.7 percent in April 2020. Further, the average hourly earnings have been growing decently by 4.6 percent between July to December last year compared to 3.5 percent growth in the first half of 2021. This also suggests that the Americans have been getting a steady paycheque which allows them to indulge in various goods and services. Such connotation rhymes well with the 20.2 percent average retail sales growth during 2021 after posting a meager 0.2 percent in the prior year.
Against such a backdrop, it is rather perplexing to see the sharp fall in the equities market at a time when the economy is growing nicely and the Fed is doing their job to remove the medication in order to ensure the right doses to be prescribed. It is like asking the medical doctors for more drugs when the patient is already showing signs of a speedy recovery. Perhaps, the equities market is merely looking for a reason to offload their shares in order to lock in the gains that they have made. That can be the sensible explanation as institutional investors may need to realize their profits to deliver dividends to their investors. Whatever the reasons may be, one should be looking at the big picture to gain better insights and understanding. Otherwise, we would be blurred by the gyrations, volatility, and irrationality, leading to suboptimal decision-making. Granted there will be downside risks that could easily alter the way we see things. Nonetheless, the vaccination for Covid-19 has been identified and successfully rolled out. In a nutshell, the Fed has spoken and therefore, we shall brace for impact.
By Dr Mohd Afzanizam Abdul Rashid-Chief Economist
Bank Islam Malaysia Berhad
