The prominent monetary policy meeting of the Federal Reserve ended on May 5 with its committee members unanimously voting for a 50 basis point hike in interest rate. This represents a 0.75% – 1% increase in the target federal-funds rate interval that is in line with market expectations. In addition, the Fed decided to gradually increase the upper limit of balance sheet reduction to USD 95 billion in three months, through a monthly reduction pace at USD 47.5 billion, starting from June 1. This level of balance sheet reduction is believed to be below expectations, reflecting a cautious stance on the part of the Fed. Fed chair Jerome Powell has basically ruled out the possibility of an interest rate hike of 75 basis points in the short term, adding that there is broad consensus within the Fed that the subsequent meetings should each see a rate hike of 50 basis points. Foreseeing a high probability of a soft landing for the U.S. economy, the Fed is hoping to suppress labor market demand without triggering a rise in the unemployment rate.
Overall, the Fed's recent statements have not been more radical than expected. On the one hand, these statements relieve the market sentiment against an excessively aggressive pace in the Fed's policy tightening. On the other hand, they paint a clearer picture of the Fed's future policy path, which is beneficial for market policy expectations. However, based on the current situation, and as previously stated by ANBOUND, the issue of inflation will continue to be a major challenge for the Fed for a long time. As things stand, its ability to control inflation is not something to be optimistic about right now.
Figure 1: Forecast Path of the Federal Reserve's Balance Sheet Size
Source: The Federal Reserve; Research Division of China International Capital Corporation
What is noteworthy is that the Fed has made radical policy tightening statements on numerous occasions in an attempt to control market sentiment. Yet, the actual policy implementation has been moderate. This approach gives the market an impression of a dovish monetary policy and it has become the Fed Chair's method of communicating with the market in a bid to calm the investor's nerves. China International Capital Corporation identifies Powell's habitual restraint in making statements on the day of the Fed meeting, as well as his post-meeting leanings toward hawkish policy, as possibly the Fed's attempt to direct market presumption. For most people, dealing with inflation remains the fundamental concern.
The Fed sees the economy as relatively optimistic, based on the fact that U.S. household spending and business investment remain strong despite month-on-month negative GDP growth. According to the statements, with strong employment growth paralleling a significant decline in the unemployment rate, the subsequent tight labor market may still result in a rise in the unemployment rate. This is while the inflation is still far above target, with the risks of accidental upward inflation, and the continuation of inflation beyond expectation.
These, coupled with the additional upward inflationary pressure resulting from the Russia-Ukraine conflict, jointly constitute a source of stress on economic activities. Meanwhile, premised on the absence of a sizeable rise in the unemployment rate, Powell maintains that the U.S. economy is tenacious enough to reduce excess demand and avoid a recession. These statements indicate that the issue of inflation will remain the Fed's key policy concern for quite a long period, even without the onset of stagflation.
Secretary of the Treasury Janet Yellen predicted steady growth of the U.S. economy as well as a possible soft landing for the economy in tandem with the Fed's measures to lower inflation. She highlighted the combined imperatives of skills and luck for the Fed to realize the economic soft landing, believing that the Fed is capable of accessing these. Yellen as one of the officials responsible for U.S. economic policies does not seem fully confident of the country's ability to realize economic soft landing. According to the Fed, achieving a soft landing for the U.S. economy requires not only luck but also patience in anticipating a natural fall in demand. In fact, the market is skeptical of the Fed's ability to simultaneously raise interest rates while also achieving an economic soft landing. It is also concerned about the negative effects of a rapid rate hike on the economy and capital investment.
As with the unlimited quantitative easing in 2020, the pace this time with which the Fed tightens policy is faster than that of measures taken in previous years. For the first time since May 2000, the resolution of the latest Fed meeting saw the Fed raising 50 basis points in a single rate hike. This is also the first time since June 2006 that the Fed raised interest rates consecutively in two meetings. Moreover, its imminent balance sheet reduction will parallel its rate hike, a historically rare situation. Regardless of the short-term relief in market sentiment, there are medium- and long-term policy risks that will affect the capital market trend. Under the ongoing inflation, the impacts of the Fed's increased tightening measures on the economy and financial market will gradually become apparent.
For investors, the Fed's transparency in the rate hike and balance sheet reduction enables not only clear expectations on policy trends but also allows them to adjust their asset revaluation plan. For the U.S. economy, on the other hand, there will definitely be high inflation for some time to come. ANBOUND has previously stated that global disruption in the industrial chain and increased geo-risk will result in the phenomena of economic distress and economic shortage. Therefore, inflation will be difficult to control in the short term if this trend continues. The implication is that the Fed is faced with an uneasy task in fulfilling its policy targets.
The Fed's tightening policy pace is immensely detrimental to the global economy. At present, the Fed is forcing the world's major economies to follow in its policy footsteps. Major economies like Brazil, India, and the United Kingdom have already implemented or are in the process of implementing rate hike policies. Such global liquidity contractions harm the global economy, with emerging markets and less-developed countries bearing the brunt of the damage. With increasing differences in economic cycles and policy cycles, the Chinese economy and monetary policy will be impacted negatively as well. The narrowing, even upheaval, of the interest spread between China and the United States, has already resulted in cross-border capital flow, putting unprecedented and increasingly visible pressure on the RMB exchange rate. In terms of macroeconomic policy, the implication is that China must strengthen its countercyclical regulation in tandem with the implementation of a cross-cycle structural policy. China should make every effort to achieve the goal of consistent economic growth while avoiding deflation.
Final analysis conclusion:
While the Fed's latest policy resolution is relatively moderate, its interest rate hike and future balance sheet reduction are more aggressive than previous measures. The latter reflects its strong desire to keep inflation under control. It is unclear whether such hasty policy tightening will result in an economic soft landing. The negative effects of such an approach on the global market are becoming more apparent.
