Fed’s monetary policy: after the QE, the QT!
Wedneday December 19th, The Federal Reserve (Fed) raised its main policy rate by 0.25% from 2.25% to 2.50%, which was widely anticipated by markets. More importantly, Jerome Powell, the head of the United States (US) central bank, qualified his intentions for future rate hikes in 2019. Thus the members of the Federal Open Market Committee (FOMC) anticipate only two rate increases next year and no more than three, as previously planned. It had been ten years since the Fed’s main policy rate had reached that level. The FOMC members believe that we are now approaching the level of “neutrality” of monetary policy, defined by a key rate that does not stimulate, nor curb activity. Turning to the Fed’s mandate, it is true that with an unemployment rate that has fallen since September 2018 to 3.7%, its lowest level in fifty years, an inflation of around 2%, and an estimated growth in the fourth quarter of 2018 of nearly 3%, the Federal Reserve has largely achieved its goal of full employment in a stable price environment.
However, the US economy is threatened by a risk of inflationary acceleration of wages because of the labor shortage that is rife in many sectors. The high growth is also the result of tax cuts implemented since January whose effects will fade from 2019, while the tariffs imposed by the Trump Administration to virtually all its trading partners may adversely affect price stability and growth prospect in the short term. In addition, the international economic environment is not very buoyant: the worrying slowdown in European growth and the Chinese slowing down of activity are also negative factors for the US economy, which the Fed must take into account.
The Fed’s monetary policy tightening is also reflected in the Central Bank’s balance sheet
Behind the successive rate increases that started at the end of 2015 is a reality less commented by the markets. Indeed, since October 2017, the central bank started a reduction in its balance sheet. The Fed had deliberately inflated it from 2009 by accumulating debt to fight deflation and keep rates artificially low. For more than a year, the Washington, D.C. based financial institution has allowed USD 50 billion of debt instruments to go unrenewed every month. But this return to normal has a restrictive effect on the credit markets. We have moved from Quantitative Easing (QE) to Quantitative Tightening (QT). The QT has a significant effect on credit markets as central banks in Europe and Japan also cease to accumulate debt recently.
Among the endogenous causes of economic cycles, the role of central banks has often been singled out. It is true that if the Fed continues to raise rates, the recessionary effects may outweigh the desired effects of such a monetary policy. Donald Trump could take advantage of the situation to attribute the responsibility for a cycle reversal and therefore a recession during the race to his succession from 2020. Fears of a recession in the world's largest economy are not expected to wane in 2019, quite the contrary, suggesting a less abrupt end of cycle than in 2008 after the gloabl financial crisis…
Julien Moussavi, Head of Economic Research
Sources: Beyond Ratings, Datastream