Article’s background

Last two years saw central banks world over raising interest rates and cutting money printing. This is the so-called tight monetary policy stance in the language of central banks and financial markets. This monetary tightening is the text book macroeconomic drug available to central banks to fight inflationary pressures. They applied it this time to fight three decades high inflationary pressures caused by Corona pandemic-induced disruptions in global supply chains. 

The cause for inflation in class room economics is the excess aggregate demand (for goods and services) that pushes prices in general. The monetary policy prescription to fight inflation irrespective of causes is to reduce the growth of aggregate demand to match the aggregate supply externally determined. The monetary drug in the prescription is to raise interest rates to curtail credit creation of the banking system which will slow down the aggregate demand. 

The underlying belief is that the money available in the market for financing the aggregate demand will be curtailed by the reduced credit creation. Therefore, the monetary policy to central banks is the conventionally memorized price stability drug. Therefore, central banks are not bothered by any side effects of the drug to the economy.

As the world economy is largely driven by the US currency through international capital flows, it is the US monetary policy that leads monetary policies of the rest of the world. Central banks in other developed countries led by Bank of England (BOE) and European Central Bank (ECB) follow suit the US monetary policy to keep their currencies competitive with the US currency. 

Therefore, central banks of other countries who are driven by foreign currency reserves have no option but to follow suit the US monetary policy. Therefore, the fact of the matter is that inflation as well as monetary policy happen in global waives, irrespective of the country stories fabricated by respective central banks. However, to financial markets, whole thing is a speculative profit gamble. 

Therefore, this article is to shed some light on the macroeconomic appropriateness of the monetary policy as reflected from current issues in the US (Fed) monetary policy based on information revealed from the last monetary policy press conference held on 13 December 2023.

Present US monetary policy stance in nutshell

1. Policy objective

Maintaining a 2% of inflation on average over the longer run. This is based on Fed’s three statutory objectives, i.e., stable prices, maximum employment and moderate long-term interest rates in the US.

2. Fed’s last monetary policy decision on 13 December 2023

• Holding policy interest rate, i.e., federal funds rate target, at 5.25%-5.50%

• Continuation of Fed balance sheet reduction on a monthly phase as has been announced

3. Policy instruments decided

• Interest rate paid by the Fed on bank reserve balances at the Fed: 5.4%

• Standing facilities
  • Overnight repo operations (Fed buying Treasury securities – injecting reserves) at minimum bid rate of 5.5% up to aggregate operation limit of US$ 500 bn daily
• Overnight reverse repo operations (Fed selling Treasury securities – moping up reserves) at minimum offering rate of 5.3% with a per-counterparty limit of US$ 160 bn daily
• Fed balance sheet reduction
• Roll over at auction the amount of Fed’s holding of Treasury securities maturing that exceeds US$ 60 bn monthly.
• Reinvest agency mortgaged-backed securities maturing that exceeds US$ 35 bn monthly

First two instruments are to keep federal funds rate (overnight inter-bank market rates) within the Fed target range of 5.25%-5.50%. The third instrument is to reduce the Fed’s holding of securities and assets (i.e., money printing) gradually at a monthly phase.

4. Present monetary status of the monetary policy tightening cycle so far

• A sharp increase of the policy interest rate by 5.25% from 0.0-0.25% in March 2020 to 5.25%-5.50% so far

Sharp Increase from early 2020 to deal with the Pandemic

• A marginal reduction of the Fed balance sheet by about US$ 1.2 trillion with a reduction of the holding of Treasury securities by about US$ 1 trillion from the peak around US$ 9 trillion in mid-2022.

Sharp increase from early 2020 to deal with the Pandemic

• Bank reserve balances at the Fed stand around US$ 3.5 trillion without a noticeable reduction

5. Fed staff projections

6. Immediate market response

• Wide-spread view that the Fed has reached the policy interest rate peak as revealed from above Fed staff projections

• The Fed pivot towards policy rate cutting cycle since 2024

• Various speculations on the extent and speed of the rate cutting cycle

Immediately after the press conference, market interest rates fell intra-day noticeably, for example, 10-year Treasury yield declined to about 3.8% from 4.2%. In fact, the yield has been continuously falling from 4.9% to 4.2% expecting the Fed pivot. In response, Fed officials commented that the need for the Fed to cut rates would be less if market rates would fall in that way. Therefore, some market analysts commented that the Fed was outsourcing the monetary policy to the market.

Highlights of statements made by the Fed Chairman Jerome Powell at the last press conference

• Inflation is still too high, ongoing progress in bringing it down is not assured, and the path forward is uncertain.

• Tighter financial and credit conditions for households and businesses are likely to weigh on economic activity, hiring, and inflation. The extent of these effects remains uncertain.

• Tight policy is putting downward pressure on economic activity and inflation, and the full effects of our tightening likely have not yet been felt.

• In determining the extent of any additional policy firming that may be appropriate to return inflation to 2 percent over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.

• The unemployment rate remains low, at 3.7 percent. Strong job creation has been accompanied by an increase in the supply of workers: The labor force participation rate has moved up since last year, particularly for individuals aged 25 to 54 years, and immigration has returned to pre-pandemic levels.

• GDP is on track to expand around 2-1/2percent for the year as a whole, bolstered by strong consumer demand as well as improving supply conditions.

• While we believe that our policy rate is likely at or near its peak for this tightening cycle, the economy has surprised forecasters in many ways since the pandemic, and ongoing progress toward our 2 percent inflation objective is not assured. We are prepared to tighten policy further if appropriate.

•  If the economy evolves as projected, the median participant projects that the appropriate level of the federal funds rate will be 4.6 percent at the end of 2024, 3.6 percent at the end of 2025, and 2.9 percent at the end of 2026, still above the median longer-term rate.

• When we started out, right, we said the first question is how fast to move, and we moved very fast. The second question is, you know, really, how high to raise the policy rate, and that’s really the question that we’re still on here.

• We still have a way to go. No one is declaring victory. That would be premature, and we can’t be guaranteed of this progress.

• The economy could cool off in a way that enabled inflation to come down without the kind of large job losses that have often been associated with high inflation and tightening cycles. So far, that’s what we’re seeing.

• If you have growth that’s robust what that will mean is probably we’ll keep the labor market very strong. It probably will place some upward pressure on inflation. That could mean that it takes longer to get to 2 percent inflation. That could mean we need to keep rates higher for longer. It could even mean ultimately that we would need to hike again. It’s the way our policy works.

• A common theme is that while inflation is coming down, and that’s very good news, the price level is not coming down. Prices of some goods and services are coming down, but overall, in the aggregate, the price level is not going down, so people are still living with high prices, and that is something that people don’t like.

• What will happen with that is wages are now, real wages are now positive, so that wages are now moving up more than inflation as inflation comes down, and so, that might help improve the mood of people.

• We felt since the beginning that it would be a combination of two factors. The first factor is just the unwinding of what happened in the pandemic, the distortions of supply and demand, and the second thing would be our policy, which was weighing on aggregate demand and actually making it easier for the supply side to recover because of lower demand.

• This inflation was not the classic demand overload pot boiling over kind of inflation that we think about. It was a combination of very strong demand, without question, and unusual supply side restriction, both on the goods side but also on the labor side, because we had a participation shock.

The highlights above show the kind of theoretical/conceptual background that the Fed and all other central banks take on the justification of monetary policy decisions.

They all seem to gamble on the balancing point between inflation control and economic downturn based on numbers. Therefore, monetary policy has become a mode of math.

One good thing is only the US monetary policy is not commented by the IMF.

Response of Major central banks

Based on Fed staff projections and the tone of the Fed Chairman at the press conference, financial media world over started speculating that the Fed’s rate hike cycle is now over and the Fed is poised to commence the rate cutting cycle since 2024.

The monetary policy decisions of the ECB and BOE took place on 14 December and were to keep current policy rates unchanged at 4.00%-4.75% of the ECB and 5.25% of the BOE.

The response of both central banks to the question raised by the media whether they were ready to follow the Fed pivot was that they were not ready as the inflation was still high above the 2% target. The central bank of Canada also affirmed same stance.

However, the central bank of Japan at the policy meeting held on 19 December affirmed the continuation of the present two decades ultra-loose monetary policy until extremely high macroeconomic uncertainties surrounding the economy are eased and annual inflation exceeds 2% target and stays above the target in a stable manner. Accordingly, two policy instruments will continue.

• Policy rate of -0.10% paid on bank reserve balances and 

• Yield curve control-based open market operations to keep 10-year government securities yield around 0% with the upper bound of 1% allowed to the market

However, brave talks of western central banks based on inflation front in response to the speculated Fed’s rate cutting cycle are not real. In contrast, their policy response will depend on the extent of currency appreciation in the case of short-term capital inflows on higher interest rates. Therefore, the rate cutting cycle will not be as competitive as rate hike cycle followed primarily to fight currency depreciation under the guise of inflation control. Therefore, what is really underlying the monetary policy is the capital flows and exchange rates. The data dependence story of the monetary policy is this.

As developing countries are driven by foreign currency reserves, their central banks will tend to keep interest rate high as usual for capital inflow purposes. However, they will fabricate the normal story of anti-money printing and persistent inflationary pressures to support high interest rate policies. In contrast, in the US rate hiking cycle, they have no option but to raise domestic interest rates faster than US rates to attract foreign capital and to manage import-dependent economies. 

Market gamble on monetary policy

Immediately after the Fed policy decision, former New York Fed President Bill Dudley responded that the Fed pivot was a game because the Fed would not be able to commence the rate cutting cycle as speculated, given the downward stickiness of inflation to firmly around 2% although it had fallen sharply.

It is not secret that financial market participants gamble on profit from the outlook of inflation and interest rates based on Fed’s diverse policy communications. Accordingly, market participants also have diverse projections on interest rates and inflation and engage in speculative trades.

The pivot towards the commencement of the rate cutting cycle was perceived by the market based on the Fed staff projections (shown above) and specific views expressed by the Fed Chairman at the press conference.

The Fed and market participants gamble mainly on the outlook of growth, unemployment rate and inflation based on old Philp curve version. Their main thrust is whether the economy is heading for recession along with high interest rates and falling inflation. They debate whether the monetary policy will end up in soft landing (light recession) or hard landing (significant recession). 

This is based on the old version of the inverse relationship between interest rates and demand, growth and employment. The matter the Fed most worries is about strong labour market with high wage growth and low unemployment rate despite its ultra-tight monetary policy for nearly two years. The Fed Chairman at the last Senate hearing expressed that a loss of two million jobs would be fair to have inflation bringing back to 2% that would benefit all Americans.

Accordingly, monetary policy is nothing but a persistent gamble between central banks and markets.

Public concerns over the democracy of monetary policy

The purpose of the monetary policy is to decelerate credit creation in order to slow down the expansion of aggregate demand, given the aggregate supply as determined externally. This is questionable in modern monetary and supply side economics on several grounds.

• First, credit creation takes place digitally in bank book entries while simultaneously creating deposits as money to be spent. Therefore, credit is supply/bank driven variable without much impact from the demand side of credit.

• Second, the supply of credit is not affected by interest rates as credit is a rationed product of banks. Therefore, credit supply will be affected only if liquidity sources routinely used to balance financial inflows and outflow shrink. This can happen only if a large volume of credit is settled by borrowers including the government. 

• Third, demand for and supply of goods and services are integrated through credit and modern payment instruments in the modern monetary economies and, therefore, there is no basis for demand-driven inflation as believed in the monetary policy. Therefore, lags between the demand, supply, credit and prices as assumed in monetary policy stories are outdated concepts.

• Fourth, any of macroeconomic links of the monetary policy are not proved by real world economic data so far and, therefore, remain to be old concepts. That is why central banks follow rate hiking cycles and reverses over years at deferent speeds and rates as they are not sure of their actual outcome and performance. The data dependence is the scapegoat used to explain such protracted policy actions and lags.

• Fifth, as in the case of all state policies, monetary policy is another bureaucratic day job that causes immense uncertainties to markets because markets are driven by credit and money in modern monetary economies. Therefore, the monetary policy is behind economic bubbles linked to credit.

• Sixth, central bank money printing to fund the overnight inter-bank on wholesale basis and risk-based rationed supply of credit by banks are the prime sources of large disparity in credit distribution and resulting economic disparities of sectors and households.

However, central banks in developing countries also follow similar monetary policy models of developed market economies thinking that developing economies also operate in market mechanisms similar to developed economies. Therefore, many of these economies led by Sri Lanka have now got into bankruptcy connected to foreign capital and foreign reserves that have been explicitly promoted by monetary policies for macroeconomic management for decades. Further, they are in the move again to revive same capital based foreign reserves for stabilization on political objectives.

This is where our leaders should have the knowledge on how national democracies and currencies are used to uplift human development through modern monetary and supply side economics.

(This article is released in the interest of participating in the professional dialogue to find out solutions to present economic crisis confronted by the general public consequent to the global Corona pandemic, subsequent economic disruptions and shocks both local and global and policy failures.)

P Samarasiri

Former Deputy Governor, Central Bank of Sri Lanka

(Former Director of Bank Supervision, Assistant Governor, Secretary to the Monetary Board and Compliance Officer of the Central Bank, Former Chairman of the Sri Lanka Accounting and Auditing Standards Board and Credit Information Bureau, Former Chairman and Vice Chairman of the Institute of Bankers of Sri Lanka, Former Member of the Securities and Exchange Commission and Insurance Regulatory Commission and the Author of 12 Economics and Banking Books and a large number of articles published. 

The author holds BA Hons in Economics from University of Colombo, MA in Economics from University of Kansas, USA, and international training exposures in economic management and financial system regulation)

Source: Economy Forward