Coyness for policy

| Updated on July 30, 2021

The Fed may appear coy for now but has little option other than to move towards policy normalisation

The statement of the US Federal Reserve Chairman Jerome Powell post Wednesday’s Federal Open Markets Committee (FOMC) meeting indicates that the Fed is being extremely cautious as far as the signalling of its monetary tightening schedule goes. With economic indicators, including inflation, implying that the withdrawal of the easy monetary policy can begin soon, financial markets have been quite nervous of late. However, the FOMC continued the stance adopted in its previous meeting — to continue an accommodative stance until the economy gets on a sustainable growth path, while closely monitoring progress and initiating discussions on the manner and timing of tapering monthly bond purchases. The statement seems to have assuaged markets, which have become highly dependent on the liquidity supplied by the monthly bond purchases of $120 billion and the dollar carry trade fuelled by the near zero policy rate in the US. This complacency among market participants is, however, not expected to last long as monetary tightening by the Fed is inevitable.

The Fed is already having a tough time explaining why it is keeping the rates low despite the soaring inflation. With strong growth in the US leading to higher demand, inflation has been staying above the Fed’s target of 2 per cent over the last three months. The Fed is, however, maintaining that the inflation is due to transitory supply bottlenecks and base effect and insisting that it will subside in the coming months. If inflation continues to stay elevated, policy rate action may become imminent. The Fed has been pointing towards weak labour force participation as an indicator of underlying risk to growth. It is also right in waiting to see the impact of the delta variant of Covid-19 on demand in the coming months. But continuing the easy money policy for too long may have negative consequences on the long-term growth. The US’ government debt now accounts for 115 per cent of GDP, thanks to the additional stimulus funding since last March.

Continued printing of money by the Fed is leading to an overheated equity market, increased appetite for riskier assets such as crypto currencies, floating of Special Purpose Acquisition Companies (SPACs), non-fungible tokens, higher commodity prices, and so on. The US housing market is witnessing a large jump in demand as well as prices, with many economists warning of a bubble there. With investment funds from the US accounting for over 50 per cent of global investible funds, the Fed’s policies are fuelling asset price inflation across countries. The Fed need not worry too much about a taper tantrum as a price correction in financial markets could, in fact, be healthy, taking prices closer to their intrinsic value.

Published on July 30, 2021

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