Monday, March 27, 2023

Challenges to Fed’s Potential Policy Shift

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By Chan Kung & Wei Hongxu

At the monetary policy meeting held on June 17, the Federal Reserve decided to keep monetary policy unchanged by keeping near-zero interest rate, as well as maintain the scale of QE bond purchases.

This policy meeting also brought two notable changes, i.e., an increase in its forecast for inflation and economic growth this year, and an increase in the two policy tool rates. More concerning for the market is the fact that the Fed’s expectations signal that more than one rate hike is more likely in 2023. The Fed expects a rate hike to come sooner than it did in March this year, when it unveiled its expected interest rate path. These changes signal an imminent shift in the Fed’s monetary policy.

However, ANBOUND researchers believe that this policy cycle will not be a smooth one, as the Fed’s monetary policy will be difficult or even volatile under the pressure of rising inflation and capital markets, and its policy shift will inevitably face several challenges.

The Fed, in its decision on interest rates, still insists that the rise in inflation is temporary and a short-term consequence of rising demand in the economy. As a result, it decided to keep the policy rate near zero and the scale of QE bond purchases unchanged, but it also adjusted its inflation forecasts. The Fed’s preferred inflation gauge, the Core Personal Consumption Expenditure (PCE) Price Index, is expected to rise 3.4% from a year earlier, up from a forecast of 2.4% in March. They also revised U.S. economic growth forecast for 2021 to 7% from the 6.5% forecast in March. This is something that has never happened before. Fed Chair Jerome Powell also acknowledged that the short-term change and long-term continuity of inflation had been greater than previously thought. This change means inflation has become a key concern for the Fed, providing the basis for a future policy shift.

In response to the excess liquidity reflected by the continuous growth of reverse repos, the Fed has raised the interest rate on excess reserves (IOER rate) held at the U.S. central bank from 0.10% to 0.15% and also lifted the rate it pays on overnight reverse repurchase (ON RRP) from zero to 0.05%. As it stands, this adjustment has been anticipated by the market against the backdrop of the recent surge in the size of reverse repos. This also reflects the Fed’s intention to use policy tools to alleviate the excess liquidity situation. Despite the Fed’s signal to raise interest rates, this technical adjustment has less impact and will not have much impact on the market.

What concerns the market most is the expectations of the Fed’s policy officials, who released a dot plot showing the Fed will raise interest rates in 2023, earlier than previously expected. As the U.S. economy continues to recover strongly, 7 out of 18 committee members expect at least one rate hike in 2022, compared with 4 in March and 11 unanimously expecting at least two rate hikes by the end of 2023, according to the dot plot. Fed Chair Jerome Powell told reporters after the meeting that committee members had “mentioned” about scaling back the Fed’s USD 120 billion monthly pace of asset purchases, which they said would continue until there was “further substantial progress” towards the Fed’s goals of full employment and 2% inflation target.

While the market has become more clear-cut about the prospect of the Fed stopping QE and moving towards higher rates, the employment target is now often overlooked. As things stand, the current employment situation remains unsatisfactory, which should be the biggest obstacle to the Fed’s policy change, which is the main reason for the Fed to stick to its current policy. Fed officials expect the unemployment rate to fall to 4.5% by the end of the year, unchanged from their forecast in March, indicating no change in their estimates of the employment situation.

The U.S. unemployment rate was 5.8% in May, still well below the Fed’s target of “full employment”. The meeting minutes show that several committee members cited raw material and labor shortages and supply chain bottlenecks that could limit the pace of recovery in manufacturing and other sectors.

The labor market continues to improve, but it is still far from the goal of full employment, with 8.4 million fewer jobs than before the pandemic. Changes in the working population structure may continue to depress labor force participation rates. In this regard, the Fed’s monetary dilemma is actually getting worse, given the current trends in inflation and employment. Capital market concerns about the prospect of Fed’s rate hikes may also further slow down the pace of Fed’s policy adjustments. Therefore, in our view, the future course of Fed monetary policy adjustment is not exactly optimistic.

From the perspective of the Fed’s QE policy cycle post-2008 financial crisis, after four rounds of QE in nearly four years, the Fed began to discuss the withdrawal of QE in May 2013, and began to substantially reduce the scale of QE in December 2013, until QE was reduced to zero in November 2014. The exit process took nearly a year, while the rate hike started in December 2015, and it has taken nearly two and a half years since the policy shift. In March 2019, the Fed stopped the process of raising interest rates under pressure from then-President Donald Trump and from the markets after the sharp volatility in the U.S. capital markets. For Fed Chair Jerome Powell, who has gone through this process, the challenge of maintaining the Fed’s independence will be even greater.

From what has happened since the pandemic, the Fed’s rapid rate cuts and its large-scale QE have made the intensity and pace of its easing policies unprecedented. With the U.S. economy recovering rapidly, markets are also betting that the pace of policy change will be similar to the pace of the last policy tightening. This judgment is still reasonable in light of the rapid rise in inflation. The Fed is likely to begin tapering QE in the third quarter or before the end of the year, with a complete QE exit by the end of 2022. However, what cannot be ignored is that, with the last easing policy resulting in a rise in U.S. macro leverage and an unprecedented boom in capital markets, future policy exits will actually face more difficulty and the impact on capital markets will be more dramatic. The Fed’s greatest policy challenge is its ability to strike a balance between containing inflation and maintaining buoyant capital markets.

Final analysis conclusion:

With inflation rising and the economy recovering quickly, the Fed’s monetary policy meeting signaled a shift in policy, further brightening the prospect that it will end its loose policy and move toward higher interest rates. That said, there are risks and constraints to this process, and there will be some twists and turns that will challenge the Fed’s policy shift.

About the author:

Chan Kung

Founder of Anbound Think Tank in 1993, Chan Kung is one of China’s renowned experts in information analysis. Most of Chan Kung‘s outstanding academic research activities are in economic information analysis, particularly in the area of public policy.

Wei Hongxu, graduated from the School of Mathematics of Peking University with a Ph.D. in Economics from the University of Birmingham, UK in 2010 and is a researcher at Anbound Consulting, an independent think tank with headquarters in Beijing.

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