Explained: US Fed’s withdrawal of stimulus and its impact

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The US Federal Reserve said Wednesday that it will curtail its extraordinary policy support for the American economy more quickly than predicted and underscored its plans to hike interest rates three times next year. Amid surging inflation and sliding unemployment, Fed Chair Jerome Powell said the US economy is growing at a “robust pace” even as it “faces risks” from the Covid-19 pandemic. But with inflation likely to persist longer than the Fed had earlier projected, Powell said the central bank needed to address the threat of runaway prices to help the economy sustain its growth.

The new projections are being seen as a definitive move to frontload the reversal of the central bank’s expansionary monetary policy put in place in early 2020 to invigorate the American economy amid the Covid-19 outbreak. Part of this support was in the form of an extraordinary bond buying programme, which was intended to bring down long-term interest rates and catalyse greater borrowing and spending by both consumers and businesses. It is this plan that is now being wound down, albeit at a faster rate. Alongside the bond buying programme, the Fed also had slashed its funds target rate to zero. A faster unwinding of the bond buying programme also means that interest rate hikes in the US are likely earlier than expected.

The announcement and the timing

The Fed’s announcement comes amid criticism that the US central bank has fallen behind the curve on inflation. Late last month, the United States’ Labor Department had reported that retail inflation had spiked to 6.2 per cent in October. Wednesday’s Fed announcement is being seen as an attempt by the central bank to wrest back the narrative on the inflation issue.

The announcement effectively means that the Fed will accelerate the tapering of its bond purchases, scaling back by $30 billion a month instead of the $15 billion pace it announced just in November. This, according to Bloomberg analysts, “opens up the possibility that policy makers could raise the fed funds rate from its current range of 0% to 0.25% as soon as the first half of 2022” and that the fresh updates to the Fed’s so called “dot plot” forecast of the short-term benchmark shows a median expectation among policy makers for three interest-rate increases next year, up from less than one projected in September.

“The economy no longer needs increasing amounts of policy support,” Powell said in a news conference yesterday. The pace of inflation is “uncomfortably high”, he said after the end of the Fed’s latest two-day policy meeting.

The US central bank is currently buying $90 billion a month in bonds, down from $120 billion in October, and has been reducing those purchases by $15 billion a month. But in January, it will reduce those purchases by $30 billion, to $60 billion, and will be on track to end them altogether in March, Powell said, according to a Reuters report.

Policy signals and impact

Like other central banks such as the Reserve Bank of India, as the US Fed conducts monetary policy, it influences employment and inflation primarily by using policy tools to control the availability and cost of credit in the economy. The Fed’s primary tool of monetary policy is the federal funds rate, changes in which influence other interest rates — which in turn influence borrowing costs for households and businesses as well as broader financial conditions. Additionally, the bond-buying programme, also known as quantitative easing, was put in place in early 2020 as an extraordinary measure to help the financial markets and the economy counter the impact of the pandemic. This bond buying is an unconventional monetary policy tool (that was deployed during the global financial crisis as well), using which the central bank purchases longer-term securities from the open market in order to increase the money supply and incentivise lending and investment. Buying these securities augments the supply of new money in the economy, and ends up dampening interest rates, while also expanding the central bank’s balance sheet.

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The tapering off of the bond buying plans now signals a move towards policy normalisation and a progressive reversal of the interest rate trajectory in the economy.

When interest rates go up in an economy, it becomes more expensive to borrow; so households are then less inclined to buy goods and services, and businesses have a disincentive to borrow funds to expand, buy equipment or invest in new projects. A subsequent lowering of demand for goods and services ends up depressing wages and other costs, in turn bringing runaway inflation under control. Even though the linkages of monetary policy to inflation and employment are not direct or immediate, monetary policy is a key factor in tackling runaway prices.

Impact on EMEs, including India

Theoretically, a signal to hike policy rates in the US should be a negative for emerging market economies, especially from a debt market perspective. Emerging economies such as India tend to have higher inflation and higher interest rates than in developed countries. As a result, investors, including Foreign Portfolio Investors, tend to borrow in the US at lower interest rates in dollar terms, and invest that money in the bonds of countries such as India in rupee terms to earn a higher rate of interest.

A hike in rates in the US could have a three-pronged impact. When the Fed jacks up its policy rates, the difference between the interest rates of the two countries narrows, thus making countries such as India less attractive for the currency carry trade. A high rate signal by the Fed would also mean a lower impetus to growth in the US, which could be yet negative news for global growth, especially when China is reeling under the impact of a real estate crisis. Higher returns in the US debt markets could also trigger a churn in emerging market equities, tempering foreign investor enthusiasm. There is also a potential impact on currency markets, stemming from outflows of funds.

Global shares and bond yields rose on Wednesday after the Fed’s statement. The rupee had on Wednesday fallen below the 76 per US dollar level as foreign fund outflows intensified following global strengthening of the US dollar ahead of the Fed meeting.

In India, benchmark equity indices were up in early trade on Thursday.

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