The spike in inflation forced the Fed to start reducing the purchases of Treasury bonds and mortgages it had started in March 2020 – it started to reduce the amounts of liquidity it was injecting into the US and global financial system – and foreshadow the start of a cycle of rate rises, from negligible levels, from March this year.
The Fed, and investors, thought that might be a gentle and prolonged cycle – one or two 25 basis point rate increases this year and then, maybe, the 2023 start of a gradual sale of the nearly $US5 trillion ($7 trillion) of assets the Fed has accumulated over the course of the pandemic.
With inflation raging, those expectations changed abruptly. The markets now expect at least three or four rates rises this year – some analysts are tipping five or more – as the Fed tries to bring US inflation under control. The assets sales — “quantitative tightening” — could begin as early as March.
In a perverse way, the sell-off in financial markets sends a positive signal that economies and lives are returning, perhaps not to pre-pandemic conditions, but a new and more stable post-pandemic normal.
On Wednesday the Fed’s Open Market Committee, which sets US monetary policy, will hold its first meeting for the year. While there is no expectation that it will actually do anything at that meeting what it says may well determine what happens in financial markets this week. It either calms then or provokes an even bigger wave of selling.
More aggressive language on the outlook for rates and a more definitive timetable for an earlier start of the assets sales could cause new tremors for sharemarkets which are, even after the sell-off this year, still about 30 per cent above their pre-pandemic levels.
While there is plenty of scope for rates to rise and sharemarkets to fall to deflate the bubbles generated by the unprecedented and ultra-expansionary monetary and fiscal policies implemented in developed economies in response to the pandemic – there are those predicting a proper crash – it should be noted that interest rates remain at historic lows and will do so even as the official rate cycles turns.
Economic growth and company profits are strong, the world is slowly learning to live with COVID-19 and there are some signs that the supply chain disruptions that have had a major influence over inflation rates are starting to ease. Real economies aren’t in bad shape.
Companies like Netflix, Zoom and Peloton that benefited from the pandemic’s lockdowns and the wariness of households – are now deflating, savagely.Credit:AP
In a perverse way, the sell-off in financial markets sends a positive signal that economies and lives are returning, perhaps not to pre-pandemic conditions, but a new and more stable post-pandemic normal.
The Fed could, of course, get cold feet in response to the markets’ turbulence. It wouldn’t be the first time the Fed backed off and reversed a planned policy course after a market “tantrum.”
That happened most famously in 2013 when the Fed announced plans to begin tapering the rate of assets purchases it was still making in response to the 2008 financial crisis and bonds yield soared. It happened again in late 2018 when the sharemarket fell more than nine per cent in response to the Fed’s plans to raise rates, causing the Fed to abandon that plan.
The US inflation rate is so high and shows no signs of abating, however, which would make it difficult for the Fed to blink in the face of a markets backlash.
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Where Wall Street and the Fed go so does the rest of the world. Our market, while it might not have the same exposure to tech stocks as the US, will still follow its direction. Investor sentiment/risk appetites and capital flows in a globalised market environment mean developed world markets move in the same direction.
Similarly, the Fed’s outsized role in financial markets and the global financial system mean that increased rates in the US create pressure for higher rates elsewhere (or depreciating currencies) as capital flows towards the more attractive yields.
It won’t be just American investors, analysts and economists who will be fixated with what the Fed has to say this week.
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