Opinion
The US Fed is under watch for more than just its policy rate
Summary
- Global investors anticipate a rate cut by the US central bank this week, but asset values are subject to effects of the Federal Reserve’s policy of quantitative easing or tightening. Ultra-easy money has widened wealth inequality. Whether it will acquit itself on financial stability is the question.
The odds-on bet across financial markets globally is on a rate cut this week by the US Federal Reserve, now that inflation there looks closer to its 2% target and weak job growth is in focus. A rate reduction would mark a reversal of the central bank’s hiking spree that elevated America’s policy rate from 0-0.25% in early 2022 to 5.25-5% by mid-2023 to quell an outbreak of inflation it mistook as transitory.
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It was not as drastic as the Fed’s rate spike of the early 1980s, but has again shown the power of costly credit against price flare-ups. If the US suffers only a slowdown in the wake of tight money (a ‘soft landing’), the Fed would’ve staged a fine recovery from its pandemic stumble. Note that price instability had been fading as a scare in the US after the Cold War ended, thanks to globalization’s gift of cheap imports, IT-aided cost efficiency and other factors.
The Fed had seen the US economy expand faster without an overtight labour market and payroll-pushed inflation. However, by the time covid disrupted supply chains, froze activity and pushed the Fed into ultra-loose money mode, at least one of those price deflators had weakened. With the outlook so dicey, holding prices steady was no easy task, surely. It took 30 months, but to the Fed’s credit, the job is mostly done.
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It is time, then, for the Fed to focus on job generation, the other part of its dual mandate. While this may mark a return to its rate policy as usual, with money being squeezed and eased gently to smoothen boom-and-bust cycles, it is also a good moment to ask if other risks lurk. The Fed’s assets/liabilities had more than doubled within two years to about $8.9 trillion by April 2022.
Did this mega infusion of money inflate asset values to such frothy levels that skittish markets are inevitable? Signs abound of equity inflation, with stock tickers in a league apart from business earnings. Bull runs on the back of easy money are only to be expected. The question is how far extra dollars at play can safely go.
A roaring boom of the 2000s led by low-rate lending ended in a Great Recession (2008-09) as credit risks fell victim to complexity and spun out of control, sending shudders across the US economy and forcing bank bailouts to stall domino collapses. Some regulatory safeguards were imposed in response to that crisis, while the Fed’s ‘helicopter’ shower of rescue dollars was backed by a mea culpa over its failure to fend off the Great Depression (1929-39) by easing money early.
A new era of quantitative easing (QE) had begun, done via bond-buying in bulk to soften long-span rates. Subsequent moves to wind it down faced market tantrums, with private profits apparently aligned with—or addicted to—its QE policy. The Fed had been shrinking its balance sheet only gingerly when the pandemic prompted its biggest ever rescue.
Also read: The Fed is behind the curve. There’s still no need to panic.
The Fed’s policy tightening of 2022-23 is yet to fully ripple across the US economy, but it may also be too early to tell how wisely (or not) its multi-trillion stimulus was used. Since QE tends to raise moral hazard and animate risk-taking, investors hope it didn’t get too heady. Last year, a few banks wobbled as rising rates hit their bond portfolios. Other cracks could surface too.
As the Fed moves to reduce rates, its asset/liability path will be under investor watch. A policy of ultra-easy money isn’t costless. It has widened wealth inequality, for example, and whether it’ll acquit itself on financial stability is a question worth trillions.
