Implications of United States Federal Reserve Policy
It is widely acknowledged that the United States Federal Reserve exerts significant influence over the economy and financial markets. The Federal Reserve is responsible for conducting monetary policy so as to promote the goals of achieving maximum employment, stable prices, and moderate long-term interest rates. The Federal Open Market Committee (FOMC) makes decisions on monetary policy that directly influence the overall demand for goods and services in the national economy. When this level of demand is judged to be too strong, unemployment is likely to fall to potentially unsustainable levels and inflation is likely to rise. This is the scenario that financial markets are currently assessing with a view to implementing policies to mitigate the perceived risks involved. Under these circumstances, the Federal Reserve can use various tools to guide economic activity to a more sustainable level, while controlling inflation, by tightening monetary policy to raise interest rates, in the expectation of meeting its policy objectives. The FOMC’s principal method of applying monetary policy is by changing its target for the federal funds rate, the interest rate that banks pay to borrow reserve balances overnight. Institutional investors, such as pension funds, endowment funds, and insurance companies, will typically monitor FOMC activities very closely, with particular attention given to the release of the minutes following each FOMC meeting. The minutes of the latest FOMC meeting, held on December 14-15, 2021 were released on January 5th.
The FOMC’s discussion of economic and financial conditions at this meeting reflected the changing environment over the two previous years. Prior to the emergence of the COVID-19 pandemic, the level of inflation was below the annual target of two percent. In response to the pandemic, very large financial stimulus programs were introduced and interest rates were pushed downwards to extremely low levels. As the effects of these measures worked their way through the economy, inflation rose recently to levels well above the FOMC’s target. Many observers felt that in the latter part of 2021 the FOMC was in a situation where market conditions for interest rates and inflation had not been anticipated or acted upon in a timely fashion. Market speculation indicated a high probability of future FOMC action to raise interest rates and reduce the size of the Federal Reserve’s balance sheet that had been expanded by asset purchases. Market participants’ views on the expected path for the federal funds rate, as implied by a measure of overnight index swap quotes, indicated that expected rate increases would occur earlier than previously expected.
The December FOMC meeting minutes clarified the Federal Reserve’s policy intentions regarding the target range for the federal funds rate and the tapering of future asset purchases. The FOMC agreed to undertake market operations to maintain the federal funds rate in the target range of zero to one-quarter percent. However, the FOMC issued a directive to change the increase in monthly holdings from $60 billion to $40 billion for Treasury securities and change the corresponding increase from $30 billion to $20 billion for holdings of mortgage-backed securities beginning in January. The FOMC had previously referred to the rise in inflation as transitory, but with the benefit of observing actual conditions and assessing the future outlook, it agreed to remove the previous questionable reference to transitory factors affecting inflation in its post-meeting statement, noting that supply and demand imbalances had continued to contribute to elevated inflation. Financial markets reacted negatively to the FOMC minutes, expressing concerns about the potential higher future course of interest rates, anticipating a series of future interest rate increases occurring sooner than had been previously expected. Also reflected by the markets was the flattening of the yield curve as short-term rates increased, with non-parallel shifts in rates at various durations along the curve. Of particular immediate concern for its impact on price volatility was a reassessment of the outlook for certain sectors of the equity market. The gap between current inflation levels and the FOMC’s target level is judged by some market participants as indicative of potential headwinds to be expected for the financial markets. Short sellers sense opportunities in both bonds and equity securities and are taking appropriate actions to profit from the inflationary environment. Institutional investors will face many challenges as the expected scenario for higher interest rates emerges. Declines in bond prices are being felt and are further anticipated as interest rates climb. Sector rotation in the equity market is being experienced as market participants seek a greater emphasis on value and reduce or abandon exposure to overvalued holdings in more speculative sectors of the market. Asset allocation decisions and asset/liability management strategies become of greater importance under the anticipated conditions. While the risk of rising interest rates to asset values is evident, institutions with obligations for future payouts must also address this challenge in terms of its impact on both assets and liabilities, with particular regard to mitigating the net asset/liability impact.