The current US economy is at a crossroads when it comes to the suitability of various monetary policy measures. On the one hand, global political uncertainty and several macroeconomic indicators evince support for a cautious interest rate policy environment. On the other hand, there has also been widespread commentary calling for multiple rate rises over the next year in order to protect against the risk of an overheated US economy. This article seeks to explore the impact of anticipated interest rate increases and attempts to shift some of the public attention from drastic short term measures towards a more sustainable long term balance sheet approach. Ultimately it is suggested that a smoother policy environment is more desirable for the health of the US economy than repeated interest rate hikes.
Why Raise Rates?
First, it is necessary to explore the underlying rationale of interest rate adjustments and the associated impact on the economy. The current US economic climate is characterized by low unemployment, rising inflation, declining terms of trade and an appreciating dollar. In light of this background, there is increasing pressure on the Federal Reserve to raise interest rates going forward. Higher interest rates serve to limit economic demand by increasing the cost of funding, fostering a higher propensity to save and reducing export competitiveness by way of currency appreciation, amongst other contractionary effects. On the one hand, it is evident how rising interest rates can serve to keep the US economy in check by reeling in excessive demand. Further support for this proposition can be drawn from the implications of the proposed expansionary fiscal policy measures of the Trump administration. The inflation risk associated with increased infrastructure spending and taxation reform measures provide ample support for an increase in interest rates. In particular, the republican border-adjustment tax (BAT) is likely to lead to importers passing on price increases to domestic consumers. As a result of current economic conditions and proposed policy measures, it is apparant why the Federal Reserve seeks to raise interest rates.
Concerns about the Fed’s Balance Sheet-Time to Sell?
In an environment driven by repeated calls for higher rates, it is pertinent and useful to consider other available options to guard against inflationary pressure. There has been an increasing focus on the structure of the Fed’s balance sheet. Prior to the crisis in 2008, the Feds balance sheet listed assets at approximately 800 billion. Nine years on and this figure has now risen to 4.5 trillion. This trend arose from the quantitative easing program rolled out in response to the crisis. As the subprime mortgage market collapsed, the Fed purchased several government bonds and toxic mortgage backed securities to combat declining market liquidity as default rates skyrocketed. The interesting point to note is that this program ended in 2014, yet the Fed has continued to implement a policy of reinvesting matured bond proceeds. Many have suggested that this level of assets is unsustainable and have called for the Fed to start running off its assets.
Taper Tantrum 2.0?
Although many economists agree that balance sheet measures provide a more gradual and long term form of economic relief, there are still certain risks that policy makers should take into consideration. For instance, a poorly communicated monetary policy runs the risk of repeating the taper tantrum that we saw back in 2013. Markets were sent into a whirlwind after an announcement by former chair of the Federal Reserve, Ben Bernanke, who indicated that the Fed would soon start to curtail its bond purchase programs. Following this, we saw a massive increase in the sale of treasury bonds, leading to a spike in bond yields and declining equity markets as prices plummeted due to the surge in supply. This highlighted the fickle nature and sensitivity of markets to central bank monetary policy and the importance of communication in advance of any market transactions undertaken by the central bank.
Although most commentators are calling for higher rates, there still exists a degree of uncertainty in many marketplaces around the world. This climate warrants a cautious policy framework. Whilst higher rates will protect against the risk of inflation, the continued upward trajectory of the US economy has not yet solidified. The magnitude, timing and finer details of Republican policy measures remains to be seen. Rather than raise rates and prematurely curb demand, it might be best for the Fed to openly communicate a long-term asset reduction and reinvestment plan to bring its balance sheet back to a more sustainable level. This should be communicated well in advance so that it is gradually priced into the market. This smooth, long-term policy approach will give the central bank time to ensure the economy has fully recovered. Furthermore, should we see significant financial deregulation and another toxic ungoverned derivative environment, a lighter balance sheet will give the government sufficient room to respond.