Pandemic Monetary Policy - Will the US Central Bank (Fed) respond to the pandemic inflation risk aggressively as speculated by Markets?

 

Rising inflationary pressures in the US since the 3^rd quarter of 2021 have caused speculative market dealers to gamble on the future path of the monetary policy. In general, markets expect the central bank to tighten the monetary policy primarily through raising its interest rates (or policy rates) to address concerns over rising inflation in line with standard monetary textbooks. The past monetary policies show that such tightening is not an overnight act but a phase-wise lukewarm act or a nimble that spans for several years by taking into considerations of the response of the economy as reflected in incoming data with various time lags.

In general, markets price inflationary pressures in financial products by adding an inflation risk premium to market interest rates or rates of returns. Therefore, even without central bank monetary policy actions, market interest rates move in parallel to inflation expectations that are partly influenced by the present inflation trend too. Treasury yield rates, short-term market interest rates and stock prices are the market prices that are adjusted quickly and frequently in inflation expectation and speculative environment.

In addition, market expectations on the possible monetary actions and the path also add to speculative activities of market participants by rebalancing their investment portfolios and economic activities for speculative profit. In some instances, significant volatilities of the markets are witnessed depending on levels of speculations. However, long-term investments and economic activities follow the long-term value and, therefore, do not lean with such speculations.

The market activity and the monetary policy in the US affect almost all countries across the globe as the US Dollar is the most popular global reserve currency used for trade, investments and foreign reserves. Therefore, the US market speculative activities can have significant spillovers to the rest of the world even causing international instabilities as witnessed in 2017/2018. A more persistent risk of such spillovers is now seen through the market speculation on fast tightening of the current pandemic monetary policy that prevails from March 2020.

Speculative Environment just prior to the Fed Monetary Policy Meeting on 18-19 January 2022

Although the US President initially stated that the present inflation was a global phenomenon, he later stated that the inflation was a matter for the Fed to handle. At the Senate Confirmation hearing held on 13^th January, the Fed Vice Chair nominee Lael Brainard stated that, as the inflation was a monetary phenomenon, the Fed would take appropriate policy action to bring the inflation under the control.

The Fed Chair Gerome Powel has been continuously stating that the mandate of the Fed is the maximum employment and price stability and the Fed will use its full range of tools to deliver the mandate. Meantime, his interpretation to the present inflation pressures has been that supply and demand imbalances related to the pandemic and the reopening of the economy and bottlenecks and supply constraints have contributed to elevated levels of inflation persistent than initially anticipated. 

In addition, at the Senate Confirmation hearing held on 11^th January, he stated that all mainstream economic forecasts on inflation have been found to be wrong and quantitative easing would be necessary depending on the economy if interest rates were very low as there would be no tools.

Markets were driving the Fed to tighten the monetary policy aggressively beginning the 18th-19th meeting. Their comments covered an initial rate hike of 50 bps, four to five rate hikes and significant runoff of the Fed balance sheet during the year. In this environment, a stock market selloff with US 10-year US Treasuries rising to around 1.86% was reported. The price falls from the mid-January to 27^th January were 4.9% for Dow Jones, 7.2% for S&P 500 and 10.3% for Nasdaq. The rise in the US 10-year Treasury yield in this period was 9.4% or nearly 16 bps.

Fed Monetary Policy Decision at the Meeting on 18-19 January 2022

The Fed policy decision in the present context involves in two tools, i.e., interest rate (Federal funds rate target) and the Fed balance sheet or assets. The Fed’s standard tool is its interest rate that sets the target for the overnight federal funds rate (Inter-bank lending rate). The balance sheet sets the amount of money printing made available to the wider economy to address liquidity imbalances in various sectors. This is the tool broadly known as Quantitative Easing (QE) invented to handle the global financial crisis 2007/09. The Fed resorted to both tools aggressively to handle the pandemic crisis.

Accordingly, the Fed with these tools attempts to carry out a sort of price control in the money market although other state price controls in many markets have failed. The federal funds rate target is the price set for the overnight inter-bank funds market while the balance sheet is the monetary warehouse used to fill the mismatch between the demand for and supply of money at that price.

At this meeting, the Fed did not touch both tools.  The Fed’s the interest rate at present is 0-0.25% as compared to the pre-pandemic rate of 1.50%-1.75% whereas the balance sheet is around US$ 8,757 bn, an increase of US$ 4,584 bn or 110% of money printing from the pre-pandemic level. Therefore, the Fed monetary policy is at historic loose at this stage.

However, the Fed at its meeting held on 3^rd November 2021 had decided to taper the monthly net asset purchases of US$ 80 bn of US Treasuries and US$ 40 bn of Agency Mortgage-backed Securities (total US$ 120 bn) on a monthly basis so that the net purchase would be terminated at the end of March 2022. 

Accordingly, the Fed decided to terminate the purchases as scheduled by reducing the purchase of Treasuries at least to US$20 billion per month and of agency mortgage‑backed securities at least to US$10 billion per month in coming February and March. 

In a way, this is an action to stop the expansion of the balance sheet. However, open market operations, i.e., asset purchases and sales on repo and reverse repo basis, will be conducted to keep the fed funds rate at desirable level within the fed funds target range of 0-0.25%. Therefore, this will cause temporary increases or declines of the Fed balance sheet.

Therefore, all market speculations turned out to be incorrect and destabilizing. Therefore, soon after the Fed policy decision was communicated, stock prices rose with Dow Jones by 2.8%, S&P by 4.4% and Nasdaq by 6.6% while the US 10-year Treasury yield fell to 1.75% level as on 1^st February 2022.

Policy Communication at the Post-meeting Press Conference held on 27 January 2022

Some of the views on the Fed monetary policy outlook shared by the Fed Chair Jerome Powel communicated at the above meeting are as follows.

• The Fed monetary policy has been adapting to the evolving economic environment, and it will continue to do so.

• Fortunately, health experts are finding that the Omicron variant has not been as virulent as previous strains of the virus, and they expect that cases will drop off rapidly. If the wave passes quickly, the economic effects should as well, and we would see a return to strong growth. That said, the implications for the economy remain uncertain.

• Labor demand remains historically strong. With constraints on labor supply, employers are having difficulties filling job openings and wages are rising at their fastest pace in many years. Over time there are good reasons to expect some further improvements in participation and employment.

• Like most forecasters, we continue to expect inflation to decline over the course of the year.

• We will use our tools both to support the economy and a strong labor market and to prevent higher inflation from becoming entrenched. And we will be watching carefully to see whether the economy is evolving in line with expectations.

• In light of the remarkable progress we have seen in the labor market and inflation that is well above our 2 percent longer-run goal, the economy no longer needs sustained high levels of monetary policy support. That is why we are phasing out our asset purchases and why we expect it will soon be appropriate to raise the target range for the federal funds rate.

• Of course, the economic outlook remains highly uncertain. Making appropriate monetary policy in this environment requires humility, recognizing that the economy evolves in unexpected ways. We will need to be nimble so that we can respond to the full range of plausible outcomes. With this in mind, we will remain attentive to risks, including the risk that high inflation is more persistent than expected, and are prepared to respond as appropriate to achieve our goals.

• These high-level principles clarify that the federal funds rate is our primary means of adjusting monetary policy and that reducing our balance sheet will occur after the process of raising interest rates has begun. Reductions will occur over time in a predictable manner primarily through adjustments to reinvestments so that securities roll off our balance sheet. Over time, we intend to hold securities in the amounts needed for our ample reserves operating framework, and in the longer run we envision holding primarily Treasury securities.

• The Committee has not made decisions regarding the specific timing, pace, or other details of shrinking the balance sheet, and we will discuss these matters in upcoming meetings and provide additional information at the appropriate time.

• It is not possible to predict with much confidence exactly what path for our policy rate is going to prove appropriate. And so, at this time, we haven't made any decisions about the path of policy. And I stress again that we'll be humble and nimble.

• Both sides of the mandate are calling for us to move steadily away from the very highly accommodative policies we put in place during the challenging economic conditions that the economy faced earlier in the pandemic… It will soon be appropriate to raise the target range for the federal funds rate… I think there's quite a bit of room to raise interest rates without threatening the labor market.

• I also would point out that there are other forces at work this year, which should also help bring down inflation. We hope including improvement on the supply side, which will ultimately come at the timing and pace of that are uncertain. And also, fiscal policy is going to be less supportive of growth this year, not at the level of economic activity but the fiscal impulse to growth will be significantly lower. So there are multiple forces which should be working over the course of the year for inflation to come down. We do realize that the timing and pace of that are highly uncertain and that inflation has persisted longer than we thought. And, of course, we're prepared to use our tools to assure that higher inflation does not become entrenched.

• The balance sheet is much bigger. I'd say it has a shorter duration than the last time. And the economy's much stronger, and inflation is much higher. I've said this, being willing to move sooner than we did the last time and also perhaps faster. But, beyond that, it's really not appropriate for me to speculate exactly what that would be. And -- but I would point you to principle number one, which is the Committee views changes in the target rate for the federal funds rate as its primary means of adjusting the stance of monetary policy. So, we do want the federal funds rate, we want to operationalize that. And we want the balance sheet to be declining in a predictable manner, and we want it to be declining primarily by adjusting reinvestments.

• There are rules of thumbs. I'm reluctant to land on one of them that equate this. And there's also an element of uncertainty around the balance sheet. I think we have a much better sense, frankly, of how rate increases affect financial conditions and, hence, economic conditions. Balance sheet is still a relatively new thing for the markets and for us, so we're less certain about that.

• And then we will look to have that just running in the background and have the interest rates, again, be the active tool of monetary policy. That's at least the plan. I can't tell you much more about any of the very good issues about size, pace, composition, those sorts of things. But we'll be turning to all of those at coming meetings.

• And you have seen that our communication channel with the markets is working. Markets are now pricing in a number of rate increases. Surveys show that market participants are expecting a balance sheet runoff to begin, you know, at the appropriate time sometime later this year perhaps. We haven't made that decision yet. We feel like the communications we have with market participants and with the general public are working and that financial conditions are reflecting in advance the decisions that we make. And monetary policy works significantly through expectations. So that in and of itself is appropriate.

• We haven't made a decision yet, and we'll make that decision at the March meeting. We'll make a decision whether to raise the federal funds rate. I would say that the Committee is of a mind to raise the federal funds rate at the March meeting, assuming that conditions are appropriate for doing so.

• There's a case that, for whatever reason, the economy slows more and inflation slows more than expected, we'll react to that. If, instead, we see inflation at a higher level or a more persistent level, then we'll react to that. And, again, we're well aware that this is a different economy than existed during the last tightening cycle, and our policy is going to reflect those differences.

• The federal funds rate is the primary means of adjusting the stance of policy that we'll use, determine the timing and pace of reducing the size of the balance sheet to foster the dual mandate that will begin to reduce the size after we begin the process of raising rates and on and on like that.

• The economy no longer needs this highly accommodative policy that we put in place. So it's time to stop asset purchases first and then, at the appropriate time, start to shrink the balance sheet. Now, the balance sheet is substantially larger than it needs to be. We've identified the end state as -- in amounts needed to implement monetary policy efficiently, effectively in the ample reserve regime. So there's a substantial amount of shrinkage in the balance sheet to be done. That's going to take some time. We want that process to be orderly and predictable.

• We'll start the process of allowing runoff and shrinking the balance sheet at what we find to be the appropriate time. It's -- I wish I could say more. But, honestly, we haven't made those decisions. And we actually haven't even really had the important discussions on a lot of the details that we will have at coming meetings.

• So I mentioned two-sided risks. You know, a couple things. One, COVID is not over. And COVID can continue to evolve, and it's just -- we have to accept that it's not over, and the risks to it can slow down growth. And that would be -- that's sort of a downside risk from a growth standpoint. I would point to, you know, another risk is just further problems in the supply chains, which could slow down activity. And you see the situation in China has a situation there where that's their no COVID policy may cause more lockdowns. It is likely to, and that may play into – may play into more problems in supply chains. In addition, there's what's going on in Eastern Europe and things like that. So there's plenty of risk out there. And we, you know, we can't forget that there are risks on both sides.

• In response to a question that “monetary policy and fiscal policy maybe did too much to react to the crisis and that part of the inflation problem that we're having right now is because the government response, you know, collectively was more than what the economy ended up needing?” the Fed Chair stated that “I am going to leave that to the historians and, in 25 years, we'll look back at this incident, we'll have a much better basis to make a judgement about the actions that people took. It was all founded, though, in a very strong reaction to a unique historical event.”

Will the Fed respond as speculated by market participants? My view is no.

However, despite above views, markets are seen acting speculatively by expecting 4-5 rates hikes with significant balance sheet shrinking during the year 2022.

However, by carefully reading the underlying meaning and the tone of above views, I observe that the Fed is highly concerned about the significant prevalence of macroeconomic uncertainties and, therefore, it is not ready to move any further from the present policy stance until supply side bottlenecks and Coronavirus are confirmed to have been permanently eased. The Fed Chair recently made a comment that the Fed would not repeat same mistake it did by faster tightening the monetary policy in 2017/18.

Therefore, the Fed will let markets to handle inflation expectations through market interest rates and demand and supply forces without adding any fuel further to prevailing macroeconomic risks and uncertainties from the monetary policy front.

The reason behind is the global pandemic risk which is not covered in the textbook macroeconomics and monetary policy. Therefore, any act of monetary policy tightening to handle present mode of rising inflation in the past or non-pandemic textbook fashion runs huge unknown policy risks in the current context of virus variants, global supply chain problems and existing capacity impairment and productivity losses caused by the pandemic. The absolute poverty created by the pandemic is also considered to be at historic levels.

Further, the European Central Bank has communicated that it was not in any rush to tighten the pandemic monetary policy whereas the Bank of England only raised its interest rate by 0.15% to 0.25% on last 16th December 2021.

Therefore, I am of the view that it will take at least a decade for the Fed to reach at relatively tightened monetary conditions around 1.50%-2.00% of fed funds rate target.

In this context, above views of the Fed are good macroeconomic lessons to central banks in the emerging world who have already commenced or plan to commence aggressive monetary policy tightening to deal with conceptual concerns over present inflation levels and balance of payment problems in the belief of textbook monetarism and monetary formula. 

However, present global inflation is not a monetary phenomenon but an unknown pandemic phenomenon. Therefore, there is no doubt that these countries will end up in catastrophic living standards due to supply chain problems further aggravated by the impending monetary policy tightening. In the present pandemic context, monetary tightening will no doubt fail to resolve pandemic supply side bottlenecks and significant demand-supply imbalances that are the root causes of the present global inflation drive.

P Samarasiri

Former Deputy Governor, Central Bank of Sri Lanka