At a special meeting convened by the U.S. Federal Open Market Committee (FOMC) two years ago, the decision was made to reduce the federal funds target rate by half a percentage point to 1-1.25% amid worries that the novel coronavirus would bring an end to the longest economic expansion in the history of the United States.
That was on 3 March 2020. The FOMC’s action, followed by another full percentage point reduction in the benchmark interest rates a mere 12 days later and a new round of quantitative easing, however, failed to prevent a recession from taking place. The U.S.’ longest growth streak ended after 128 months, which lasted from June 2009 to February 2020.
Turning on the financial spigots has helped households and businesses tide over the coronavirus-induced crisis with access to easy credit, which would otherwise be more expensive. The absence of this credit would also have likely resulted in a global financial meltdown.
At its peak, the Federal Reserve was injecting US$75 billion per day into money markets by purchasing treasury and mortgage-backed securities. As a result, its balance sheet rose sharply to US$9 trillion as of last month, more than doubled from US$4.2 trillion just before the pandemic. Given the potency normally associated with such stimulus measures, the inability to sustain market confidence has given rise to questions over their effectiveness.
Seen as his first major victory in office, U.S. President Joe Biden signed a massive US$1.9 trillion Covid-relief package in March 2021. The combination of easy monetary and fiscal policies has, however, created the unpleasant side effect of spiralling inflation, which the Federal Reserve had until recently regarded as a passing phenomenon that would dissipate along with the Covid-related lockdowns and supply chain disruptions. That did not, however, quite pan out.
Consumer price growth in the U.S. hit a 40-year high of 8.5% in March, while the job market continued to improve with the unemployment rate dipping to a new two-year low of 3.6% in March. The Federal Reserve did well in responding quickly and decisively at the early stages of the pandemic but appears to have stumbled in addressing the spectre of inflation.
After initially taking a wait-and-see attitude, the Federal Reserve has now changed course and adopted a more aggressive approach to tackle rising prices. At the recent March meeting, the decision was made to raise the target range for the federal funds rate by a quarter percentage point to 0.25-0.5%, the first hike since 2018.
At the time of writing, traders are overwhelmingly pricing in multiple half-point adjustments this year, with the first coming in May. Minutes from the March meeting signalled the Federal Reserve Board’s intent to move towards a “neutral” monetary stance within a short space of time. This suggests that interest rates could increase to as high as 2.3-2.5% by the end of the year, with the U.S. economy running at full strength and inflation remaining stable under a “neutral” interest rate environment.
The Fed will also start switching from quantitative easing (aka QE) to quantitative tightening (QT) as early as May. Depending on economic conditions, the size of its balance sheet could be reduced by as much as US$95 billion per month after a three-month phase-in period, which will be achieved by not reinvesting the proceeds from maturing bonds. Such a strategy, at full speed, will be equivalent to a shrinkage of balance sheet of just over US$1 trillion a year.
It is unclear whether the Fed will follow through with its plans but if it does so, the pace of QT is likely to be much faster than that of a few years ago. After the monetary easing cycle commenced in April 2008, it took some seven years before the Fed began to raise rates, in December 2015, and a further two years or so before shrinking its balance sheet based on a monthly deleveraging rate of US$50 billion.
It is unclear how the U.S. economy will respond to the latest decision by the Federal Reserve to tighten money supply. For market watchers, movements in bond yields may offer some clues. When the economy is healthy, long-term government borrowing rates – driven mainly by investors’ assessment of economic growth and inflation in the medium- to long-term – are higher than short-term rates, which are contingent on market expectations as well as the Fed’s decisions on benchmark interest rates.
In the case of the former, a higher rate reflects the borrowing cost that is associated with the privilege of taking out a loan with a longer tenor.
In early April, the yield on the 2-year U.S. bond rose above that of the 10-year bond, creating a so-called “inverted” yield curve, which stoked fears of a recession in America. Investors and policymakers have every reason to worry because historically the inverted curve has been an accurate predictor of a U.S. recession that followed a year or so later.
The longer the curve is inverted, the higher the risk of an economic downturn. Some believe that the latest inversion could be a false positive, as the U.S. yield curve has been heavily distorted given the massive bond-buying programme since the 2008 financial crisis and pandemic-related QE. As such, its credibility as a portentous metric of economic recession has been called into question.
The Fed may well lean towards the narrative that “this time is different” and assure markets that there is no need to panic. It remains to be seen whether the Fed has made the right call in betting that history won’t repeat itself and is able to win back its credibility after getting inflation so wrong. As back-seat passengers, we may only tighten our seat belts.
Wilson Chong, firstname.lastname@example.org