There is a growing possibility that the US Federal Reserve will raise interest rates several times this year in a bid to tame the raging inflation. As a rule, this kind of policy increases the so-called inflation risk premium in emerging markets, Russia included. Investors will seek higher returns; considering this trend, the Central Bank of the Russian Federation may once again raise its key rate to 9–10%.
Inflation driven higher
Inflation in the US remains high. It accelerated to 0.5% mom in December (following a 0.8% increase in November), and to 7% yoy, in line with market expectations. Prices across a wide range of goods and services accelerated from December to January; energy was the biggest contributor (up 29.2%), with gasoline prices soaring by 49.6% (against 58.1% in November). At the same time, inflation accelerated for food (6.3% against 6.1%) and used cars and trucks (37.3%).
Consumer inflation expectations for the medium term (next year) rose to 4.9% (from 4.8% in December), and for the long term (five years), to 3.1%. Despite such a high annual inflation rate — close to emerging markets in fact — we urge investors to go about it with caution because it is clearly heavily influenced by the low base effect.
We expect annual inflation in the US to average at 5.5% and decline to 4.0% by the end of this year. Global food prices are expected to slow down, while American producers will boost their production capacity and sort out their logistics problems. As a result, their cost pass-through into the final product prices will be less than last year.
Another deflationary factor is unprecedented growth of American companies’ profits. After-tax profits in Q3 2021 accounted for 11% of the US GDP, breaking the previous record of 10.7% set in Q2 2020. Before that, the historic high had been 10.6% (Q1 2012). That should allow companies to cover some expenses without increasing end prices in 2022.
Federal Reserve System actions
The prices of many goods and services continue to grow fast, which forces the Federal Reserve System to toughen up its rhetoric. Chairperson Jerome Powell recently announced that inflation rate would remain high throughout the first half of 2022.
When adjusting the key rate, the Federal Reserve System factors in the personal consumption expenditure (PCE) price index. In November 2021, PCE was 0.6% higher than in October 2021 and 5.7% higher than in November 2020. The core PCE index, which is not based on food or energy prices, increased 0.5% last November month-on-month and 4.7% year-on-year, its annual growth rate reaching maximum since 1982. The Federal Reserve System expects a PCE of 2.2–3.0% in 2022.
The market believes that the agency will start raising the key rate as soon as the first quarter. In December, the Federal Reserve System released a “dot plot” of its officials’ votes regarding prospective rates. The officials expect to increase the rate paid on reserve balances three times this year and three times in 2023, based on media forecasts.
Market analysts’ current shared prognosis matches the official forecasts: they only expect three or four raises up to around 1% this year. However, we expect a more drastic increase (potentially, six times of 0.25% or higher each) to around 1.5%, which should be equivalent to the yield growth of UST-10, or 2.5%. We believe that US economic recovery and the steadily high inflation rate will eventually prompt the Federal Reserve System to take a more radical approach than the market expects.
Investors are not particularly worried about the current state of the US economy. The expected US GDP growth in Q3 2021 surprisingly increased from 2.1% to 2.3% (in annual terms), following improved consumer expenditure dynamics. In Q2 2021, the US GDP grew 6.7%. At its December meeting, the Federal Reserve System updated its prognosis and now expects the annual GDP growth of 5.5% (decrease from 5.9%). However, the system raised the economic growth prognosis for 2022 to 4.0% (from 3.8%).
Faster inflation rate growth is the latest trend in the US economy, prompting the Federal Reserve System to act faster, with a chance of several key rate raises this year. There are indicators that the US economy has reached full employment (the unemployment rate is dropping, and wages are increasing faster). In general, this could create a new inflationary factor for the economy.
As a result, investors will be basing their financial models for company assessment on a higher discount rate. Companies suffering losses and expecting higher profits in the long term will be affected the most, with less effect on companies with steadily high cash flows and value stocks.
Some will even land on their feet by shifting the inflation burden on their customers’ shoulders and having the higher discount rate and capital value compensated by higher profit growth rates.
Effects on world economy and Russia
The high inflation rate in the United States is a significant factor for the world economy since it affects the monetary conditions of major central banks. The Federal Reserve System has already announced a key rate increase cycle happening shortly and the European Central Bank can be expected to make a similar decision in the next few months. The higher cost of loans will slow down the recovery of the world’s GDP.
The growing interest rate in the United States is driving up the inflation premium in emerging markets, including Russia. Investors want higher returns on investment as they see the growing nominally risk-free rate in the United States.
This means that the Russian Central Bank has to take global trends into account and raise the key rate more significantly. The key rate of the Federal Reserve System is used as a so-called neutral range of the key rate. It is possible that the Russian Central Bank will increase it from the current 5–6% to 6–7% in the next few months. The key rate might reach 9%-10%, which will limit the downward movement of Russian rates after the Russian regulator manages to lower the inflation to the target 4%.
The impact of the inflation in the US on the ruble will also depend on the central banks’ interest rate policy. If the increase of the interest rate in the US is bigger than the market expects, the dollar will firm against other currencies, while the ruble will weaken. Investors will reduce their portfolio investment in Russian assets due to a low risk premium and will pick more secure American instruments. The Russian Central Bank will keep supporting the ruble and increasing the interest rate in response to the growing inflation. Thus, the effect of the interest rate policies of the two countries on the ruble will depend on how prompt and tough the decisions of the two regulators will be.
By Sergei Konygin, Senior Economist, Sinara Investment Bank (SKB-Bank)