The US Federal Reserve has finally made the much-anticipated move, raising the target range by 25 basis points. Members of the Federal Open Market Committee (FOMC), the panel that sets the monetary policy, have also forecast that the target rate for the end of 2016 would be 1.375 per cent, indicating another 100-basis-points hike over the next year.
Fed Chair Janet Yellen has managed the path towards monetary policy normalisation quite smoothly, if the reaction of the financial markets after the move is any indication. The main signal that the move sends is that the US economy is now on a path of recovery and this seems to have buoyed sentiments worldwide.
The first move has been made, but this does not mean that the era of cheap money is over. There are various factors that will ensure that adequate finance is available to companies and governments that are struggling, so that the feeble global economy is not derailed. One, while the Fed has hiked its target rate, it is in no hurry to sell the bonds and other assets it has purchased as part of its quantitative easing programmes over the six years from 2009. Monetary policy normalisation by the Fed involves two steps: a) an increase in the federal fund rate and other short-term interest rates to normal levels, and b) reduction in the Fed’s holding of securities purchased in the course of the quantitative easing to a more reasonable level.
Rising assets So, besides hiking interest rates, the Fed also needs to trim its balance sheet that has bloated following the QE program. The assets of the Federal Reserve were $865 billion in August 2007. This expanded to $4.4 trillion by the end of July 2015. While there is no roadmap yet on selling the long-term securities purchased from banks and other institutions, once the Fed begins selling them, US treasury yields are going to shoot higher, causing another round of exodus from emerging market bonds. But this is not likely to happen any time soon. The FOMC statement says that it will continue reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities and will roll over the treasury securities that mature, until normalisation of the level of the Fed funds rate is well under way.
This means that the Fed will ensure that the rate hikes are assimilated before selling those bonds and sucking out liquidity from the system.
Two, even as the Fed is on a rate hiking cycle, other central banks, including the European Central Bank, the Peoples Bank of China and the Bank of Japan, are in no hurry to follow suit. Three, the rate hike made on Wednesday is far lower than the average Fed funds rate that has prevailed in the US over the years. For instance, the average funds rate between March 2000 and June 2006 was 3.3 per cent. In the 90s, the average was higher, at 4.9 per cent. The gradual increase to 1.375 per cent by the end of next year is unlikely to result in a sharp increase in borrowing cost. The Fed is currently ensuring that rates remain far below these averages for some time in the near future.