HOW MUCH COULD THE FED TIGHTEN MONETARY POLICY?

30.03.2022 The US central bank, the US Federal Reserve (the Fed), is the most influential on the planet. Its activities set the tone for global financial markets. How far does it plan to raise interest rates and what impact will this have?

The United States is currently experiencing high rates of inflation. The headline annual inflation rate is currently 7.9 percent while the rate that excludes volatile components such as food and energy is 6.4 percent. The Federal Reserve is now focused on bringing inflation back under control.

At its most recent meeting the Federal Reserve raised its policy rate by 0.25 percent. It also set out its plans for the rest of the year and next year. By the end of 2022 it envisaged interest rates at around 1.9 percent, by the end of 2023 they were forecast to have risen to 2.8 percent. In the context of the super low interest rates, that we have experienced over the last decade, this represents a determined and aggressive tightening of monetary policy.

However monetary tightening must also include reversing (quantitative tightening) some of the money printing (quantitative easing) that the Federal Reserve engaged in over the last decade or so. In order to inject money into the economy the Fed electronically created money and used it to buy financial assets. Over the last decade its assets have ballooned to almost USD 9 trillion. Operations to start reversing this monetary largesse are expected to begin in May. The initial pace of quantitative tightening could be be around USD 70-90 bn per month. The Fed has the possibility to sell some of its assets in the market place each month. However, it is expected to adopt a more passive approach by just not renewing some of its investments that have reached maturity.

As a result of high inflation US and global equity markets not only face the prospect of higher interest rates but also quantitative tightening. Higher interest rates will act to slow growth, while quantitative tightening will tend to put downward pressure on equity market valuations. So, in 2022 equity markets face twin head winds. Consequently, we think it is sensible to have a cash reserve in equity portfolios at present. This will allow us to take advantage of increasingly attractive valuations for purchasing securities as the year wears on.

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This post was written by Robin