The US Federal Reserve’s uncertain policy path
It has been almost a decade since the stress in the global financial system—that would later turn into the biggest financial crisis since the Great Depression—started to emerge. The recovery has been feeble and policymaking in the developed world is, to a large extent, still anchored to the after-effects of the crisis. Even though the US Federal Reserve has started the process of policy normalization, the consensus view in the market at the moment, as reflected by stock and bond prices, is that the central bank will not be able to move forward at the projected pace.
Last week, the Federal Reserve raised policy rates for the third time in six months, and also outlined its much awaited plan for shrinking its balance sheet, which has ballooned from the level of about $900 billion before the financial crisis to the present level of about $4.5 trillion. It expects to start reducing the size of its balance sheet later this year. Further, official projections showed that the central bank expects to raise rates by another 25 basis points later this year, followed by three more rate hikes next year.
But financial markets remain largely undeterred. This is in sharp contrast to 2013, when just a hint of reducing the quantum of asset purchase by the Federal Reserve led to massive volatility in financial markets across the world. One of the reasons why markets are perhaps not reacting is because they believe that weak prices will not allow the Federal Reserve to tighten policy. Inflation continues to undershoot the central bank’s target of 2%, even though the unemployment rate has slipped to a 16-year low. But the Federal Reserve is of the view that the recent drop in inflation is due to one-off factors such as the fall in prices of cellphone services. This assessment may be correct, but inflation has remained below the central bank’s target despite the economy being on one of the longest expansion streaks in post-World War II history. And all the money pumped into the system through quantitative easing over the years has failed to push inflation as desired.
Meanwhile, a number of economists are reasoning that the Federal Reserve needs to raise its inflation target. Recently, a group of economists, including Nobel laureate Joseph Stiglitz, wrote to the central bank arguing that the inflation target needs to be reassessed. The group, in its letter, noted: “...given the evidence that the equilibrium interest rate had fallen substantially even prior to the financial crisis, and that the Fed’s short-term policy rate remained at zero for seven years without sparking any large acceleration of aggregate demand growth, a reassessment of this target seems warranted.”
Interestingly, it appears that the Federal Reserve is not averse to the idea of reassessing the target. In her reply to a query on the letter, Federal Reserve chairperson Janet Yellen said: “...I would say that this is one of the most important questions facing monetary policy around the world in the future and we very much look forward to seeing research by economists that will help inform our future decisions on this.” It would be interesting to see how the debate progresses, as costs and benefits will have to be examined carefully. Just changing the target may in itself not push inflation and equilibrium interest rate, but it could end up causing major disruptions in both the financial market and the real economy, with global consequences.
In the present situation, if inflation fails to pick up—as financial markets are expecting—the Federal Reserve will find it difficult to move forward both in terms of normalizing policy rates and rightsizing its balance sheet. Monetary tightening is likely to tighten financial conditions and negatively affect economic activity and prices. But if inflation picks up, as labour market tightens and wages rise, financial markets may have to do a fair bit of adjustment.
The policy outlook in the US has undergone a significant change in the last few months. At the beginning of the year, the risk was that if the Donald Trump administration was able to push growth through higher government spending, the Federal Reserve might have to tighten policy at a much faster rate. But it appears that Trump will not be able to pursue such policies in a hurry. So it will now be important to watch whether inflation in the US moves closer to the target on a sustainable basis or not. The answer to this may not only decide how global money managers will adjust their portfolios, but could also influence the future of monetary policy. Both will have repercussions for the global financial system.
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