From The Era Of Easing To The Era Of Tightening

After half a decade of ultra-low rates in the United States, the Fed is hiking rates and moving ahead to reduce its massive $4.5 trillion balance sheet. The consequences will reverberate across the world, including Asia.

Before the Trump era, the Federal Reserve hoped to tighten monetary policy more often and aggressively than markets anticipated. But since November, US economic prospects have fluctuated dramatically, from the Trump trade to new volatility.

In its May meeting, the Fed left its target range for federal funds rate steady at 0.75-1 percent, in line with market expectations. It is likely to climb to 1.3 percent by the year-end and to exceed 3 percent by 2020.

In other major advanced economies, monetary stance has remained broadly unchanged. The European Central Bank (ECB), led by Mario Draghi, held its benchmark rate at 0 percent in April. While the ECB has signaled impending normalization, it will continue its asset purchases until the year-end. Even if the ECB begins rate hikes in 2018, they are likely to be low and slow. The rate could climb to 1 percent by 2020.

In Japan, Abenomics has failed, despite slight improvement in short-term growth prospects. As introduced by Haruhiko Kuroda, the chief of the Bank of Japan (BOJ), negative rates and huge asset purchases will continue. The rate may remain negative (-0.1%) until 2020 – by then Japan’s sovereign debt will exceed 260 percent of its GDP.

Yet, rate normalization is only a part of the story. After the Fed began its historical experiment with quantitative easing (QE), its then-chief Ben Bernanke accumulated a portfolio of some $4.5 trillion. Now the question is how his successor Janet Yellen plans to reduce it.

Adding to uncertainty is the fact that she is likely to be replaced at the end of her term in 2018 with a Republican whose views of US economy and markets are more in line with those of the Trump administration.

Subdued balance-sheet contraction

Since 2008, I have argued that, despite its hawkish rhetoric, the Fed will not be able to increase rates as early, as often and as much as it initially hoped. And nor will the Fed reduce its balance sheet as early, as often and as much as it initially signaled. Though widely different from the consensus half a decade ago, it seems now that both forecasts have been to the point. The Fed’s current objective seems to be to hike rates up to only 3 percent.