The End of Loose Monetary Policy

The End of Loose Monetary Policy
The End of Loose Monetary Policy
(c) JIM WATSON / AFP / picturedesk.com
Share post:

As expected, the US central bank is accelerating the exit from ultra-expansive monetary policy. While key interest rates are being raised quickly and sharply, the central bank balance sheet is being reduced. Investors hope for a soft landing of the economy. Risks remain elevated.

On Wednesday, 4 May, the Fed raised the key interest rates, or more precisely: the range for the key interest rate by 0.5 percentage points to 0.75 – 1 percent. This is the first increase of this magnitude since 2000 and already the second rate hike in a row. In March, the Fed had initiated the interest rate turnaround with an increase of 0.25 percentage points. At the same time, the reduction for the central bank balance sheet was announced as of June: for government bonds, initially a maximum of 30 billion US dollars per month for three months, then a maximum of 60 billion US dollars per month. For mortgage bonds (agency MBS), the balance sheet can shrink by a maximum of 17.5 billion US dollars in the first three months, then by a maximum of 35 billion US dollars per month.

Further rate hike of 0.5 percentage points announced

At the press conference, Chairman Jerome Powell said that there was broad agreement in the committee that further hikes of 50 basis points (50 basis points = 0.5 percentage points) should be on the table at the next meetings. The measures did not come as a surprise to market participants. The Fed had already prepared the market for this in the past weeks with sharp statements on fighting inflation (hawkish stance) (forward guidance). The first market reaction was even relieved (yield declines in short-dated government bonds, price rises in equities) because a major interest rate hike of 0.75 percentage points was not considered. By the end of the year, a key interest rate of 2.81 per cent is priced into the market.

There are two reasons for the quick and rapid exit from loose monetary policy: the high inflation that has persisted for months and the low unemployment rate.

Highest inflation rate in decades

Inflation rates are very high. Not only the Fed has massively overestimated its inflation forecast. In March, consumer prices rose by 0.9 percent on a monthly basis and by 6.6 percent on an annual basis (PCE Deflator, source: US Commerce Department). A good part of this can be attributed to external shocks: Supply chain problems due to supply-demand imbalances driven by the indirect Corona effects and higher food and energy prices due to the war in Ukraine. Pretty much every country is showing the highest inflation rates in decades for this year. In the US, on top of that, the big fiscal packages have strongly supported consumer demand. The key question now is whether inflation expectations will remain permanently high or whether they will only be a temporary phenomenon.

Low rate of unemployment

In March, the unemployment rate fell to a very low level of 3.6 per cent. At the same time, wage growth has increased. In the first quarter, the labour cost index grew by 4.5 per cent year-on-year (source: Bureau of Labor Statistics). The relationship between the unemployment rate and wage growth described by the Phillips curve historically becomes stronger at low values of the unemployment rate. Moreover, inflationary pressures have widened on many inflation subcomponents. Thus, there are indications that GDP is above potential.

Uncertainty factor: output gap

In principle, there are three scenarios as to how the central banks will continue to act. The determining factor is the high uncertainty about the difference between actual gross domestic product (GDP) and potential (the output gap).

  1. If GDP is only moderately above potential, central banks (the Fed) can manage a soft landing of the economy in a favourable scenario. Long-term inflation expectations would remain low in this case. However, there are two unfavourable recession scenarios.
  2. If GDP is well above potential for an extended period of time, the probability of a switch to sustained high inflation expectations increases (overheating). The central bank is “behind the curve”. In this case, central bank policy would have to become very restrictive: That is, deliberately create a recession (high unemployment) to get inflation under control.
  3. The exit from expansionary monetary policy is too fast. Central banks react to external price shocks, cannot influence inflation rates in the short run, but affect the economy so much that a recession is triggered. 

CONCLUSIONS

Our baseline scenario is a soft landing of the economy. However, the risks are heightened. In addition, it will be much harder for the Fed to react to a financial crisis with loose monetary policy in the future. At least as long as inflation remains high.

Explanations of technical terms on investment and securities can be found in our Fund Glossary: Fund Glossary (erste-am.at)

Legal note:
Prognoses are no reliable indicator for future performance.

RESPOND TO THE ARTICLE

Leave a comment Required fields are marked with *

Your email address will not be published.

Legal disclaimer

This document is an advertisement. All data is sourced from Erste Asset Management GmbH, unless indicated otherwise. Our languages of communication are German and English.

The prospectus for UCITS (including any amendments) is published in Amtsblatt zur Wiener Zeitung in accordance with the provisions of the InvFG 2011 in the currently amended version. Information for Investors pursuant to § 21 AIFMG is prepared for the alternative investment funds (AIF) administered by Erste Asset Management GmbH, pursuant to the provisions of the AIFMG in connection with the InvFG 2011.

The fund prospectus, Information for Investors pursuant to § 21 AIFMG, and the key investor document/KID can be viewed in their latest versions at the web site www.erste-am.com within the section mandatory publications or obtained in their latest versions free of charge from the domicile of the management company and the domicile of the custodian bank. The exact date of the most recent publication of the fund prospectus, the languages in which the key investor document is available, and any additional locations where the documents can be obtained can be viewed on the web site www.erste-am.com. A summary of investor rights is available in German and English on the website www.erste-am.com/investor-rights as well as at the domicile of the management company.

The management company can decide to revoke the arrangements it has made for the distribution of unit certificates abroad, taking into account the regulatory requirements.

This document serves as additional information for our investors and is based on the knowledge of the staff responsible for preparing it at the time of preparation. Our analyses and conclusions are general in nature and do not take into account the individual needs of our investors in terms of earnings, taxation, and risk appetite. Past performance is not a reliable indicator of the future performance of a fund. Please note that investments in securities entail risks in addition to the opportunities presented here. The value of shares and their earnings can rise and fall. Changes in exchange rates can also have a positive or negative effect on the value of an investment. For this reason, you may receive less than your originally invested amount when you redeem your shares. Persons who are interested in purchasing shares in investment funds are advised to read the current fund prospectus(es) and the Information for Investors pursuant to § 21 AIFMG, especially the risk notices they contain, before making an investment decision. If the fund currency is a currency other than the investor's home currency, changes in the corresponding exchange rate may have a positive or negative impact on the value of his investment and the amount of the costs incurred in the fund - converted into his home currency.

Please consult the corresponding information in the fund prospectus and the Information for Investors pursuant to § 21 AIFMG for restrictions on the sale of fund shares to American citizens. Misprints and errors excepted.