FOMC Meeting: Key Takeaways
This week, all eyes were on the Federal Open Market Committee (FOMC) meeting of the Federal Reserve, as financial markets and policymakers worldwide awaited the outcome of the committee’s deliberations. The FOMC concluded its deliberations on Wednesday with the release of a policy statement and a virtual press conference by Federal Reserve Chairman Jerome Powell.
Based on its deliberations, the FOMC signaled its willingness to accelerate plans to wind down monetary policy stimulus announced in response to the COVID-19 pandemic. In particular, the Committee reaffirmed its commitment to end the bond-buying program (known as quantitative easing) by March 2022; to initiate a rate-hiking cycle soon (most likely during the March 15-16 meeting); and to begin shrinking the Fed’s balance sheet (known as quantitative tightening) following the start of rate hikes. “With inflation well above 2 percent and a strong labor market, the Committee expects it will soon be appropriate to raise the target range for the federal funds rate,” the statement said.
The FOMC believes that these monetary policy measures will help reduce inflation to 2 percent from its current level of 7 percent, the highest in four decades. “I would say that the Committee is of a mind to raise the federal funds rate at the March meeting, assuming that the conditions are appropriate for doing so,” Mr. Powell stated during the press conference while remaining evasive about the rate hike schedule.
On quantitative tightening, the FOMC issued a separate statement titled, “Principles for Reducing the Size of the Federal Reserve’s Balance Sheet,” which emphasizes the Fed’s intention to reduce the asset holdings over time “in a predictable manner” but provides no additional details on the precise timing and pace of balance sheet runoff.
Clearly, the tightening of monetary policy will be much more rapid this time around than during the previous 2013-17 cycle. Although financial markets have already priced in three to four 25 basis points (0.25 percent) rate hikes in 2022, investors anticipate the Fed will act more aggressively to rein in persistently high inflation. Hence, investors are worried that the Fed might raise policy rates too quickly, jeopardizing the economy’s robust recovery.
First, the pace at which the Fed would tighten monetary policy would be determined primarily by inflationary pressures rather than labor market conditions. Numerous surveys and metrics indicate that inflation in the United States will remain persistently high throughout the year. The COVID-19 pandemic’s disruptions to global supply chains will persist into 2022. The factors that contributed to the global shortage of semiconductors and electronic components continue to exist. Politically too, inflation is increasingly becoming a major worry for voters heading into this year’s midterm election.
If inflation remains above 3 percent in the first half of 2022, the Fed will embark on a much faster and more aggressive rate hike cycle than markets currently expect. In this scenario, the Fed will likely raise interest rates at each of the remaining seven FOMC meetings this year. Instead of a typical hike of 25 bps, the Fed might hike by 50 bps at its June meeting.
Second, we anticipate that a balance sheet reduction will be announced at the June meeting and that the actual shrinkage may begin in the second half of 2022. Currently, the Fed’s nearly $9 trillion balance sheet is more than double that of the previous QE episode. Hence, the Fed will start the QT process immediately after the first rate hike.
While the Committee has not disclosed the pace, timing, or monthly cap for the QT process, its statement reveals the Committee’s intention to shrink the balance sheet “primarily through adjustments to the amounts reinvested in principal payments.” In other words, the Fed is unlikely to engage in active asset sales during the QT process.
However, the FOMC’s statement makes no mention of the sale of agency mortgage-backed securities (MBS) held by the Fed. If the Fed decides to sell agency MBS outright, there could be heightened market volatility. Unlike Treasury securities, agency MBS are more complicated because household mortgages back them, and thus the payment of principal and interest on MBS is contingent on household mortgage payments.
Third, we anticipate a bumpy ride for stock markets in 2022, which soared in 2021 due to the Fed’s easy monetary policy of maintaining low-interest rates and market liquidity. Increased interest rates would induce investors to flee stocks, cryptocurrencies, and other risky assets in favor of relatively safe assets like government bonds. Increased borrowing costs would also hurt corporate profits, which drive stock prices.
Heightened Risks for Emerging Markets
Propelled by a hawkish stance by the Fed, EM central banks will accelerate their own monetary policy tightening even though domestic conditions may not warrant such a move.
The EM central banks will have to raise interest rates in order to maintain interest rate differentials. Otherwise, they run the risk of experiencing sharp currency depreciation due to capital outflows. Brazil, Mexico, and Russia have all raised interest rates since September 2021, partly in response to domestic inflation dynamics and partly in anticipation of the Fed’s policy tightening. While India, Indonesia, and China will have to abandon their accommodative monetary stance and start raising interest rates this year.
Compared to advanced economies, interest rates are already very high in some EMEs, with policy rates as high as 40 percent in Argentina, 14 percent in Turkey, 9.25 percent in Brazil, 8.5 percent in Russia, and 5.5 percent in Mexico. Further rate hikes and tighter monetary policies will hamper the economic recovery in most EMEs. Rate hike pressures would be felt most acutely in Latin America, in particular, due to its high degree of financial interconnectedness with the US. As EMEs are still grappling with the economic fallout of the COVID-19 pandemic, increased interest rates will increase the cost of government borrowing, thereby undermining the ongoing economic recovery.
The US Federal Reserve’s aggressive tightening of monetary policy also implies more challenging external financing conditions for emerging markets. A stronger dollar and higher bond yields would lead to the unwinding of US dollar carry trades that have found their way into emerging markets ever since the Federal Reserve started its QE policy in March 2020. It would result in capital flight from EMEs that have benefited from the deluge of liquidity created by the Fed’s QE policy. Large and sustained outflows would exert downward pressure on emerging market currencies.
There are already signs of capital flight, with foreign investors withdrawing significant sums from EMEs such as India, Indonesia, and South Africa. In India, for instance, foreign investors have been net sellers in the secondary equity markets in the past four months, withdrawing $6.7 billion since October 2021. According to National Securities Depository Limited data, foreign investors withdrew $1.6 billion from Indian equity markets in January alone, accounting for nearly half of their total investments in 2021. The Indian rupee was Asia’s worst-performing emerging market currency in 2021, as foreign investors fled the country’s equity markets.
As global financial conditions continue to tighten, emerging market and developing economies (EMDEs) with a high stock of foreign currency debt and a low stock of foreign currency reserves may face a severe currency crisis over the coming two years.
Increased global interest rates would put upward pressure on EMDE sovereign and corporate borrowers’ foreign currency borrowing costs. Not only would they face increased refinancing costs, but they would also be restricted in their ability to issue new debt in the US dollar. Some may be unable to meet their external debt obligations in 2022.
For instance, take the case of Sri Lanka. Sri Lanka is on the verge of defaulting on its sovereign debt because its forex reserves, which stand at less than $3 billion, are insufficient to cover the $6.9 billion in debt repayments due this year to international bondholders and creditors. Despite receiving financial assistance from China and India, Sri Lanka is in the midst of its worst economic crisis in decades, with rapidly depleting foreign exchange reserves and soaring inflation. With tourism and remittance earnings severely impacted by the pandemic, the country’s dwindling forex reserves have impacted imports of essential commodities such as food, fuel, and medicines, resulting in a sharp increase in prices. The country’s policymakers have been negotiating debt relief with international bondholders for several months, but no agreement has been reached so far.
As the author has previously discussed, EMDEs should not hesitate to deploy capital controls, macroprudential policies, and other regulatory tools to protect their economies from external shocks caused by the Fed’s aggressive policy tightening.
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