March-ing on With Calculated Optimism
The Fed hiked rates by 25bps overnight, taking it to 5%. The hike comes despite the current substantial stress in financial markets, translating that the Fed is still prioritizing its fight against inflation above other considerations. In its statement to the hike, the Fed said that inflation remained elevated while employment indicators were running at a robust pace. It also stressed that US banks were sound and resilient but that the current stress in markets would mean tighter credit conditions, although J-Pow’s press conference later stated the precise level of tightening would be uncertain. It seemed to downgrade the path of monetary policy at the next meetings, saying some additional policy firming may be appropriate rather than its previous language of ongoing increases in rates. J-Pow also noted that the Fed did consider a pause at this meeting and that additional rate hikes might still be needed if the inflation fails to get closer to target levels, underscoring the level of uncertainty to the rate trajectory as it closed in the peak of the hiking cycle.
The FOMC also came with a new Summary of Economic Projections. Growth for this and next year was revised down marginally while the unemployment rate was also nudged lower. Projections for inflation rose with the Fed estimating PCE inflation at the end of the year at 3.3%, above the Fed’s 2% target and thus still necessitating a restrictive stance on policy. But there was no change to this year’s projection for where rates should end the year with the median projection of 5.125% holding, with 10 FOMC members pitching at that level while one member supported rates going up to as much as 6%, higher than the previous SEP.
Overall, the March FOMC meeting will be put down as an attempt at a dovish hike. Inflation is still an issue and hiking rates is the most effective tool to cool aggregate demand and, eventually, bring prices lower. Similar to the messaging from the ECB last week, Powell noted that the Fed has separate tools to manage liquidity stress in financial markets.
Market reaction to the Fed was somewhat clouded by a simultaneous message from Treasury Secretary Janet Yellen who seemed to rule out a blanket increase in deposit insurance, saying it was not something we are considering. Nevertheless, the 2yr UST rallied sharply on the Fed announcement as markets discounted any more tightening, with yields falling 23bps on the day to 3.9367%. The moves this month have been substantial: only as recently as March 7 the 2yr UST was trading with a 5% yield. Market pricing for rates at upcoming meetings has a 25bps tentatively priced in for the May FOMC before cuts start in earnest from the July meeting. Almost 70bps of cuts are priced in from the current effective Fed Funds rate by the end of the year.
Based on Fed’s own SEP, monetary policy will need to tighten further as PCE inflation will still be above target by the end of 2023. A median Fed Funds projection of 5.125% implies one more 25bps hike, presumably at the May FOMC meeting, though the current volatility in financial markets may prompt a pause. Economic data in the coming weeks will be key for the May meeting though it is probably too early for it to reflect much of the noise in markets. On that basis, we expect that the Fed will be able to move ahead with one more hike before holding rates unchanged over the remainder of the year. But that stable policy view is caveated by an assumption that financial strains are contained. Should markets hit the rocks again, and credit conditions tighten significantly, then the Fed may need to do less on the hiking front to slow growth and curb inflation. The odds of a May hike would then lengthen and we could bring our expectation of rate cuts—currently expected for 2024—forward to the second half of the year.
Closer at home, the latest provisional data from the UAE MoF show the consolidated budget recorded a surplus of AED 195.7bn in 2022, or 10.5% of estimated GDP, up from AED 61.5bn (4.0% of GDP) in 2021.
Total revenue grew 28.7% y/y in 2022, driven by sharply higher tax revenues which rose more than 60% y/y. The Ministry of Finance does not split out the revenue into oil and non-oil income, but the methodology notes indicate that taxes paid by Abu Dhabi’s oil and gas companies are included in tax revenue, along with taxes on foreign banks, customs duties, VAT and other taxes.
With inflation averaging 5% last year, this implies a real cut in consolidated government spending in 2022, despite surge in oil revenues. 2023 will see revenue estimates lower on the back of a lower oil price and no increase in oil production. With the new corporate income tax coming into effect in the second half of this year, it will boost revenues in over the next two years. With overall tax revenues to be around 9% lower in 2023 and projected to be a 5% increase in current spending, slightly more than expected average inflation, the budget surplus will be at AED 125.2bn this year or 6.2% of estimated GDP.
As the heat begins and we’ve enter the holy month of Ramadan, let’s see what transpires till next month which will open a new spectrum for all markets. Have a peaceful Ramadan!
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Geoffrey Muns is an Independent Financial Advisor and Planner certified from the UK, US and UAE based out of Dubai for the past 20 years. He also works in the PE/VC space and is a seasoned investment banker having worked with international banks and investment firms in the region. You may contact him at email@example.com