Exploding prices, rising wages, falling unemployment: the US Federal Reserve drew the conclusions from the latest economic data on Wednesday and initiated a fundamental turnaround in monetary policy. The monetary authorities announced in Washington that they would begin in November to gradually reduce the massive purchases of US government bonds and mortgage-backed securities. With the program, the Fed has been pumping $ 120 billion into the economy month after month since the outbreak of the Corona crisis in order to keep long-term lending rates low and to stabilize the economy. In the future, the sum is expected to drop by $ 15 billion per month.
For the US citizens, the decision to exit is likely to have no consequences for the time being, even if the borrowing costs for car buyers or builders could rise in the medium term. Nevertheless, the scope of the decision can hardly be overestimated, because behind it is nothing less than an attempt to contain inflation, to end the zero interest rate policy in perspective and to return to more normal guiding principles. Whether this will succeed is completely open.
At the beginning of the corona pandemic, the Fed had made a decisive contribution to preventing an even more dramatic crash in the US economy with its resolute interest rate cut measures. In the meantime, however, the downsides of the ultra-loose monetary policy are also becoming apparent: it is not the cause of the recent price hikes in petrol, gas and many everyday goods, which recently drove the US inflation rate to 5.4 percent. But it favors the development.
The signal that the Fed is sending with its decision is all the clearer. It does not only mean that she is now very concerned about inflation developments. Rather, there is also increasing pressure on the other major central banks in the world to take a more critical look at the price increases. The European Central Bank, for example, has so far hesitated to make a decision because the inflation rates in the 19 countries of the euro zone are very different – from 0.7 percent in Malta to 6.8 percent in Poland. But it is also a fact that the average has doubled to 4.1 percent within a few months. At 4.5 percent, Germany is even higher.
The Fed has long tried to keep long-term lending rates low
With the start of the exit from its ultra-loose monetary policy, the Fed is opening up the possibility of targeting both long-term and short-term lending rates again. Many experts already expect that after the presumed end of the securities purchase program in the spring or summer of next year, the US monetary authorities will begin to gradually raise their most important key interest rate, the so-called overnight target range, from what was last de facto zero percent. It would be the first rate hike since March 2020 and the first hike since December 2018. On Wednesday, the monetary policy committee of the central bank refrained from such a step. He stood behind Fed chairman Jerome Powell, who had recently stated that a key rate hike at this point in time would be “premature”.
Powell – and with him the majority of the 18-member committee – had long hoped that price pressure would soon go away on its own, as it was mainly due to temporary production and delivery bottlenecks as a result of the pandemic. Most recently, however, the central bank chief had to admit that the inflation trend was more persistent and broader than initially assumed. If this development continues, Powell said a few days ago, there is a risk that “in the minds of those who determine prices and wages, inappropriately high inflation expectations for the future will become established”. Should that happen, that dangerous spiral of ever increasing prices and wages could indeed set in motion, which turns a small wave of inflation into a tangible inflation problem. Powell stressed that the central bank was determined to “use our instruments in an emergency to continue to guarantee price stability”.
The decision could also trigger severe inflation
The situation for the Fed remains extremely difficult, as the pandemic is by no means over, and the economic situation remains fragile. The number of employees in the USA is still several million below the starting value in February 2020, although in view of the record number of vacancies it is not entirely clear whether the affected citizens cannot find work or are not looking for them at all.
Either way, a premature tightening of monetary policy could stall the economic recovery in the USA and wipe out all the reconstruction successes of the past few months. That would not only be a disaster for many workers who are losing their jobs again, but also for President Joe Biden’s government, which has little financial leeway after several billion dollar packages to cope with the pandemic. Conversely, if the central bank hesitates too long, the consequences could be even more serious: If the monetary authorities allowed inflation expectations to solidify and lead to a wage-price spiral, they would only have to raise key interest rates all the more sharply afterwards. The possible consequences would be a deep recession and a crash in the stock market.
In the past few weeks, it has already been possible to observe where the international trend is heading: the Bank of Canada ended its securities purchase program relatively unexpectedly, while, to the surprise of many experts, Australia’s central bank did nothing when bond yields exceeded the previously tolerated level. The Bank of England may even be planning the first real rate hike: Federal Reserve Chairman Andrew Bailey recently warned several times that “we will be forced to act” should British managers and consumers worry about permanently higher prices. The decision should be made this Thursday.