The US Federal Reserve has announced plans to wind down its quantitative easing programme, which it had put in place to provide stimulus during the Covid-19 pandemic.
Quantitative Easing, a form of expansionary monetary policy, involves the central bank purchasing large quantities of bonds (debt securities) issued by the Government and firms. This lowers the yields on these bonds, lowering interest rates across the economy and providing increased liquidity which, in theory, should incentivise consumption and investment spending, avoiding the risk of deflation.
Since the onset of the pandemic, the Fed has been buying $120bn worth of bonds every month to keep borrowing costs low. According to Reuters, the Fed’s balance sheet increased from $4.4 trillion to $8.6 trillion in assets over the course of the pandemic.
After much deliberation, the Bank has decided to taper its purchases of Treasuries and mortgage-backed securities, scaling down its purchases by $15bn per month.
The decision comes as inflation in the US has hit a 13-year high of 5.4% in September 2021, up from 5.3% in August and above market expectations of 5.3%.There have been concerns that the central bank’s stimulus efforts, in combination with supply bottlenecks and pent-up demand are responsible for the upwards pressure on inflation.
However, during the tapering announcement, Jerome Powell (the chair of the Fed) repeated his view that although inflation is likely to persist into next year, it is a temporary phenomenon due to supply-side constraints limiting production.
The tapering of bond-buying is a contractionary monetary policy which will impact the demand-side of the economy. As purchases of bonds are reduced (a fall in the demand for bonds), the price of the bonds fall, leading to a rise in the yield on bonds, raising interest rates. This should reduce consumption spending as returns on savings are higher. Hence, the taper is unlikely to have much impact on inflation as it does little to affect the supply-side of the economy.
Powell also stated that despite reduced asset purchases, the Bank would not be raising interest rates any time soon.
In the past, the usual response to rampant inflation has been a raising of interest rates to incentivise savings and dampen demand-pull inflation. However, the Bank is unwilling to take such a hawkish turn at a time when the labour market is readjusting. Powell mentioned that there are 5 million fewer US jobs compared to before the pandemic and that he wanted to ‘’allow the labour market to heal’’.
A rise in interest rates would make access to credit more expensive for individuals and raise the interest rate on linked mortgages, creating a further squeeze on already tight (due to inflation) household budgets.
For now, the Fed will wait to see how the economy fares in the coming months before changing the Federal Funds rate.
Written by Deandra Peiris