The Fed turned its back on nearly 40 years of prioritising a low inflation rate with its bold new policy. The financial markets’ reaction told us a lot | Stephen Bartholomeusz
, turning its back on nearly 40 years of prioritising a low inflation rate. The financial markets’ reaction was instructive, with the announcement barely causing a ripple.
In essence, it says that even more debt and leverage is encouraged and that the Fed will provide a rising safety net under risk assets, in the process exacerbating the wealth inequality that has already produced significant social stresses in the US and elsewhere. That has led to many central banks postulating that there has been structural change in the developed economies – that ageing populations, new capital and people-light technologies that have changed the nature of economic activity and work and the effects of globalisation have generated deflationary pressures throughout the developed world.
The Fed can anchor the short end of the US yield curve via the Federal Funds rate but the market sets the rates on longer-dated bonds and would be likely to push them up sharply if it appeared inflation were breaking out, with the threat of market tantrums and meltdowns forcing the Fed to consider more unconventional responses to avoid a financial crisis.
Whether or not the Fed has the ability to deliver high inflation via low rates – the Fed funds rate is effectively zero and may well end up being negative if the US economy doesn’t rebound strongly from the impact of the pandemic – the signals it is sending to markets are consistent with those that it, and other central banks, have been sending since the financial crisis.
There is so much debt and leverage in the system – even more now because of the government and household responses to the coronavirus – that central banks couldn’t raise interest rates even if they wanted to without precipitating a dire financial and economic crisis.
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