Fed's policy: How will it affect the markets?


In the last few months, we have witnessed a mismatch between the Fed's position and that of many market participants, provoked by the good performance of the US economy.

The situation deepened further in the last quarter, during which we saw a number of strong data on the US labor market, inflation, retail sales, and GDP.

At the same time, strong data is accompanied by the Fed's expansionist monetary policy, which could cause serious damage to the economy in the medium and long term.

1. What is the Fed's position?

The pandemic caused a significant increase in unemployment and a slowdown in economic growth, which affected businesses and consumers. The Federal Reserve undertook an easing of monetary policy, including quantitative easing, in March 2020 to counter the situation.

The central bank's main goal is to achieve a strong labor market, which is expressed in increasing employment in the country and achieving low unemployment. This goal is accompanied by the Fed's willingness to tolerate slightly higher inflation in order to achieve the goals of employment and economic growth.

2. Inflation in the United States

Inflation is one of the most important indicators, monitored by all markets, and the target values are 2% on an annual basis. The Federal Reserve did not specify how "little" it is willing to tolerate higher inflation, which for July 2021 is 5.4% on an annual basis in the United States.

The current price growth is 3.4% higher than the target values and many investors are worried that the increase will continue and the bank will not be able to counteract it. The concerns are justified, as high inflation is a fact, and the bank said in one of its latest statements that it does not currently intend to suspend quantitative easing or raise interest rates.

An option to raise interest rates earlier is also not an option, as Jerome Powell said bankers have no plans to raise interest rates until asset purchases are stopped. This means that quantitative easing must first be stopped before the interest rate can be gradually raised.

This time interval indicates that the cessation of purchases can be expected at the earliest in late 2021 and early 2022. A corresponding increase in interest rates is very unlikely to occur before mid-2022, which is why the prevailing forecasts are the first increase to occur at the end of 2022.

The timeline shows that this is а too long period during which already high inflation may increase further, especially with the current Fed policy, which continues to loosen.

Another worrying signal for many is the Fed's position on inflation in the country. Bankers are of the opinion that the current rise in prices is temporary and will not last in the long run. Even if inflation is temporary, it is not clear what values it will reach and how long it will last. On the other hand, there is a danger that inflation will not be temporary, which will lead to а too large price increase and more difficult counteraction by the central bank.

3. The US labor market

Unemployment in the United States increased to 14.7% in April 2020, as anti-epidemic measures shut down most businesses in the country.

This was the moment when the Fed decided to set the recovery of the labor market as its main goal. In recent months we see an increase in employment and a decrease in unemployment in the country, which by July 2021 was 5.4%.

The figures clearly show that improvement has been achieved in recent months, mainly due to the lifting of restrictive measures and the support of the central bank and the government for business.

However, like inflation, Federal Reserve bankers have not specified the exact values at which they will believe that the labor market has recovered. This particular question was addressed to Jerome Powell during the bank's press conference, which took place on July 28, 2021. The answer did not provide the necessary clarity, as Powell said that "they monitor different components that are related to the labor market, including employment by gender, age, race, and residence".

However, many believe that 5.4% unemployment symbolizes a restored labor market, although it exceeds the low values of 3.5% registered in late 2019 and early 2020. On the other hand, labor market recovery is a gradual process, which follows economic recovery. At the moment, the US economy is showing clear signals that it is improving in recent months, which will logically have a positive impact on employment in the country and lower unemployment.

4. How will it affect the market?

Despite the current concerns, we see that the prevailing market opinion currently supports the position of the Federal Reserve for temporary inflation. The US dollar has appreciated against major currencies in recent months, and stock markets continue to record highs.

The stock sales of February and March 2020 show us that the markets react extremely quickly when important news is published. High inflation would be just such news and would catalyze big movements if the Fed made a mistake in its judgment and witnessed a larger and longer-lasting increase in prices.

Such a situation will cause temporary chaos, as on the one hand the bank's instruments need time to start having an impact on the economy, and on the other hand, any more aggressive measures would have a negative impact on the banking, economic and financial system.

The most positive scenario includes a temporary rise in inflation, as the Fed predicts, followed by overcoming the pandemic, rising economic activity in the country, reducing unemployment, ending quantitative easing and a gradual rise in interest rates from late 2022 and early in 2023.

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