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Wednesday, September 16, 2020
The Fed's Monetary Policy Space in the Post-Pandemic Period
ANBOUND

The Federal Reserve recently held its monthly monetary policy meeting, which was the first interest rate meeting after the Fed announced its new monetary policy framework. After adopting the new average inflation target framework, how the Fed expressed its policy views and expectations to the world would be the focus of market attention. This was also the first opportunity for the market to understand the Fed's policy statement. However, regarding policy changes, the market generally does not expect any policy actions to be taken at the September meeting or any Fed meeting within the short term. From this point of view, similar to the European Central Bank and the Bank of Japan, the Fed is also in a policy window period after adopting an unprecedented super-loose policy. Many are beginning to wonder if the Fed can rescue the U.S. from the crisis after lowering interest rate to nearly zero, and at which point in the future will the Fed begin to raise interest rates. Of course, these questions may not have definite answers in the short term.

Currently, the primary goal of monetary policies of central banks around the world is to stabilize the value of their respective currencies in general. Central banks such as the Fed will use inflation as an indicator to formulate monetary policies. They often raise interest rates when inflation rises, and cut interest rates when inflation declines in order to make countercyclical adjustments. This means that central banks need to accumulate "bargaining chips" for counter-cyclical adjustments by accumulating and releasing space for interest rate policies during economic cycle changes. Therefore, central banks should have accurate expectations of the economic situation and make policy adjustments in advance. This actually reflects the professional ability and independence of the central banks.

Looking back, the Fed and other major central banks have been criticized because they did not anticipate the crisis that occurred in 2008. In response to the 2008 financial crisis, the Fed and other major central banks had to adopt unconventional policies. Through a combination of interest rate cuts and quantitative easing policies, the financial market and their respective economies were rescued in the short term, but consequently there was low interest rates and low growth in the economic trend. Affected by slow economic growth and low inflation, the Fed started raising interest rates at the end of 2015, yet the rate raised was too small, and it was suspended under President Donald Trump's pressure by 2018. As a result, it failed to accumulate enough policy space to cope with unexpected shocks. When the COVID-19 pandemic strikes, the Fed had to continue to implement unconventional policies through a super-easy means of increasing debt.

At present, the Fed's policy interest rate has dropped to near zero, and with limited amount of downward space, no one wants a rebound in inflation more than the Fed; this is so that it can raise its own interest rate "bargaining chip." Due to the dominant position of the U.S. dollar in the international economy and financial markets, most central banks will follow the Fed's policy direction and make similar adjustments. Currently, Europe and Japan are also facing the dilemma of insufficient room for conventional interest rates. The prolonged economic downturn has left central banks with no economic upturn opportunities to gain the initiative in policy space.

While the Fed and other major central banks are losing room for interest rate adjustment, the space for independence of their monetary policy is also gradually being compressed simultaneously. On the one hand, because of political interests, governments are paying more attention to economic growth and the improvement of employment levels, which puts increasing pressure on central banks to independently implement monetary policies. On the other hand, under the influence of loose liquidity, the unprecedentedly prosperous capital market of China is unable to withstand the increase in credit costs, which puts the central bank under double the amount of pressure as well as facing difficulty in normalizing monetary policy. From the perspective of the Fed's situation as a central bank, China's relatively "conservative" monetary policy has been reasonably successful in responding to the impact of the pandemic. Even under the severe impact of the pandemic on the economy, the People's Bank of China did not lower interest rates, instead it adopted structural methods such as RRR cuts and refinancing to release liquidity. Of course, this is due to the fact that China's economy is able to maintain a relatively high growth rate and can withstand high interest rates. Although these relatively conservative policies have to withstand short-term economic contractions, they also reserve room for future adjustments, and are thus in a relatively active position. From another perspective, the Fed's monetary policy choices are indeed limited by the room for economic growth.

In its recent meeting, the Fed provided quarterly forecasts for GDP, unemployment, and inflation, and announced its economic forecast for 2023 for the first time. UBS believes that if the Fed's inflation rate forecast for 2023 is still below 2%, it would mean that the next rate hike may be in the more distant future. But the immediate question is, can the Fed create new policy space by changing its policy framework to achieve its employment and inflation goals? If the U.S. economy continues to slump, it will mean that in the post-pandemic period of the next two years, the Fed may find it difficult to act and can only go further and further on the road of quantitative easing.

Final analysis conclusion:

In the post-pandemic period, even with a new policy framework, the Fed will continue to be increasingly influenced by politics and the market in its monetary policy. In addition to relying on quantitative easing that converts corporate and individual credit into government credit, it would be difficult to have conventional policy space to adjust and influence economic trends.

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