A Risky Experiment That Could Have Devastating Economic Consequences Is Underway

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The US is about to embark on a highly unusual and untested monetary policy experiment, with a lot of uncertainty surrounding its consequences. They might be harmless or cause a liquidity crisis in the financial system.

For the majority of the years following the global financial crisis, The US Federal Reserve Board has been purchasing US government bonds and bills, as well as mortgages that have been securitised, a programme it dramatically ramped up in response to the pandemic.

In June, the Federal Reserve stopped buying securities and let them run off at $US47.5 billion ($AU68.8 billion) per month.

The amount of run-off is projected to increase to $US95 billion a month, so the largest buyer of US treasuries will likely accelerate its withdrawal from markets. This shift could leave $US1.14 trillion less available in government bond and mortgage markets over the next year.

“This is a big number, and it’s going to have an impact,” says Scott Buchta, head of fixed income strategy at Brean Capital in New York.

“It’s going to put upward pressure on rates. It will make it more expensive for the US government to finance its deficit, and it will make it more expensive for corporates to finance their share buybacks and dividends.”

The Fed has signalled that it is comfortable with this experiment, arguing that it will help normalise policy and reduce its balance sheet to a more manageable size.

But Buchta says the central bank is playing with fire.

“They’re walking a tightrope here,” he says.

“They’re trying to wean the markets off this extremely accommodative monetary policy stance that’s been in place for a decade now, but they’re doing it at a time when the economy is still healing from the pandemic.”

The worry is that if rates rise too quickly, it could derail the recovery by making it more expensive for businesses to borrow money and slowing down consumer spending.

“The concern is that if the Fed takes its foot off the gas too quickly, it could cause a sharp increase in rates and disrupt the economic recovery,” Buchta says.

So far, markets have been relatively calm about the Fed’s plans, with low bond yields. But Buchta says that could change quickly if the central bank miscalculates.

“This is uncharted territory for the Fed,” he says.

“They’re flying blind here, and we could see some turbulence in markets if they get it wrong.”

The Fed’s experiment is precarious, given that it comes at a time when the US economy is already facing significant headwinds.

For Australians, this would mean higher mortgage rates and difficulty accessing affordable credit. This is why the RBA has been so cautious in raising interest rates because they know how sensitive the economy is to higher borrowing costs. So while the Fed may be comfortable with this experiment, it’s important to remember that we are not in the same position. We need to be careful that we don’t accidentally cause a recession by raising rates too quickly.

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