Ever since the financial crisis in 2008, the Federal Reserve has been on an investment spree to nurse the American economy back to health. But now when inflation has persistently stayed dangerously low under 2% for a while, the Fed seems to have uncharacteristically thrown out its crutches and resolved to increase interest rates.
This comes as a surprise to analysts and economists alike, with BlackRock's Rick Rieder speculating that "the Fed will not likely tweak its interest rate outlook for 2017 or 2018, but it could cut back on the later forecasts for higher rates."
Currently, the Fed's interest rate lies between 1% and 1.25%. Yet, according to the latest dot plot, this value is projected to even cross 2% by next year. Considering that the American economy is currently dipping and undergoing a slow growth rate, the tightening of interest rates is slightly jarring especially because higher interest rates implies less consumer spending, which would further dampen the economy.
"What the Fed is going to do this week will not surprise anyone," Lewis Alexander of Nomura Securities ironically said. "And the models predict a slow and smooth adjustment. But there is always a risk of more volatility."
The sudden change has led some to believe that the tight monetary policy is only transitory, so as to wean the economy off a $4.2 trillion portfolio in accordance with the final phase of quantitative easing. Even so, it could all be too much too soon, which could even reverse some of the positive effects the Fed had earlier on the economy.
Moreover, the fact that Trump's underhanded deal with the Democrats has come to light renders the political situation in USA extremely volatile, which further amplifies the notion that tightening monetary policy is not the way to go because consumers need economic if not political stability at least.
In keeping with its efforts to make the economy more self-sufficient, the Fed has also planned to cut down its bond holdings by around $10 billion a month for the first three months in a 60-40 ratio of treasuries to mortgage bonds.
John Rutledge of Sanafad says,
Shrinking the Fed's balance sheet is not going to be as painless as some say. It matters not a whit whether the Fed shrinks its balance sheet by selling a bond or by collecting the principal of a bond that is maturing. Either way, the person on the other side of the transaction writes a check to the Federal Reserve, which reduces the stock of bank reserves by exactly the same amount. "Not reinvesting" is no less painful that outright selling. And the pain could be substantial. At the $50 billion per month maximum the Fed announced today, the Fed would have to sell bonds every month for 3-5 years.
The crux of all of this is the fact that the Fed is trying to do the complete opposite of what it has been doing for 9 years in less than a year, which could be very problematic in terms of hindering capital formation for the average person and further slowing down the economy.
- https://www.nytimes.com/2017/09/19/business/fed-bonds-economy.html?rref=collection%2Fsectioncollection%2Fbusiness&action=click&contentCollection=business®ion=rank&module=package&version=highlights&contentPlacement=1&pgtype=sectionfront
- https://www.cnbc.com/2017/09/20/blackrock-on-fed-slimming-down-its-balance-sheet.html
- https://www.cnbc.com/2017/09/21/im-betting-against-fed-decision-to-unwind-economic-stimulus-commentary.html
- http://www.businessinsider.com/fed-rate-hike-expectations-rising-despite-weak-economy-2017-9
