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The effects of the Fed tightening monetary policy

FED accelerates tightening of monetary policy

On May 4, US time, the US Federal Reserve (FED) decided to raise the basic interest rate by 0.5 percentage points to cope with the inflation rate that is at the highest level in the past 40 years. . This move also marked the Fed’s strongest interest rate hike in 22 years.

Specifically, the Federal Open Market Committee (FOMC), the Fed’s policymaking body, raised interest rates by 0.5 percentage points to a target range of 0.75% to 1%. In a press conference after the meeting, Fed Chairman Jerome Powell said: “Inflation is too high and we understand the difficulties that inflation causes. Therefore, we are acting urgently to contain inflation. “.

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Fed Chairman Jerome Powell pledged to act urgently to control inflation (Source: CNBC)

In addition, Mr. Powell also added, “the Committee’s general view is that it is possible to continue raising interest rates by 50 basis points at the next meetings”, and said that the Fed has not considered raising interest rates yet. add 0.75 percentage points in the near future. The Fed’s goal is to create a “soft landing” to contain inflation while avoiding a slowdown in economic activity, and Mr. Powell thinks this is possible.

Along with the move to raise interest rates, the Fed also signaled it would reduce the size of its balance sheet, currently at $9 trillion. The published plans show that the reduction in the size of the balance sheet will take place in several stages, whereby the Fed will allow a certain amount of bonds to mature each month without being reinvested.

Immediately after the Fed’s statements were released, the Wall Street stock market reacted positively with all 3 main indexes simultaneously gaining strongly. The Nasdaq technology index led the market’s gains with a gain of 3.19% while the Dow Jones and S&P 500 also gained nearly 3%. The stress of investors has been significantly cooled, when the latest statements of Mr. Powell showed that the FED will have a less tough attitude in the near future in tightening monetary policy.

The far-reaching impact on the US economy

According to experts, the Fed’s continued tightening of monetary policy in the coming time will create spillover effects throughout the US economy.

The first is higher debt servicing costs. As interest rates rise, borrowers have to pay more to pay off credit, and banks become stricter in providing loans. This poses challenges for companies and slows down manufacturing business expansion.

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The US financial market will face a lot of pressure when the Fed raises interest rates (Source: CNN)

The second is pressure on financial markets. US stock indexes have fallen in recent weeks, on concerns that slowing economic growth means consumers will hold on to cash instead of spending more, denting corporate earnings while borrowing costs increase. Yields on U.S. Treasuries have surged, with 10-year Treasury yields rising to 3%, signaling investor concerns about a possible recession. Those concerns could grow if investors think the Fed has not yet acted fast and strong enough in the fight against inflation and will have to raise interest rates faster.

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The Fed’s interest rate hike is expected to help cool down the US real estate market (Source: CNN)

The real estate market is also forecast to cool down. The fact that the Fed cut interest rates to zero when the COVID-19 pandemic broke out in March 2020 added impetus to the already strong US housing market, causing house prices to skyrocket. However, by March 2022, after the first rate hike in the Fed’s tightening cycle, mortgage rates began to rise and are now over 5%, contributing to a decrease in demand and lower house prices. Residential mortgage applications slowed down and home sales began to decline in March.

Recession fears when the Fed tightens policy

The big challenge for Fed policymakers is to deal with rising price pressures without pushing the world’s largest economy into recession. Although the economy recovered strongly from the pandemic, the country recorded growth of -1.4% in the first three months of the year. If the US economy continues to grow negatively in the second quarter, the country will officially fall into a recession.

According to analysts, it is difficult to avoid the risk of a recession during an intense monetary tightening cycle, especially as rising inflation is partly due to factors beyond the Fed’s control, such as: The conflict in Ukraine and the blockade to prevent the COVID-19 epidemic in China, analyst Diane Swonk of auditing and business consulting firm Grant Thornton said: “Many Fed officials have expressed concern their skepticism about the prospect of a ‘soft landing’ of this monetary policy adjustment.”

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Experts fear the risk of recession when the Fed tightens monetary policy further (Source: Financial Times)

“At the moment, an economic recession is almost inevitable,” former Fed Vice Chairman Roger Ferguson said on May 2. “The recession is smoldering, and the probability of a recession – in my opinion – is very, very high because the Fed’s tool is a crude tool and all they can control is aggregate demand in the economy”. Ferguson forecasts a recession in 2023, but expects “it will be a mild recession”.

“The Fed has to raise interest rates high enough to maintain credibility and start cutting its balance sheet. But the Fed will have to accept an accompanying recession,” said Danielle DiMartino Booth, CEO of Quill Intelligence. “That would be an extremely difficult message to convey.”

“For now, signals suggest a “relatively low probability of a recession” but risks will increase over the next 12 months,” said Kathy Bostjancic, a senior fellow at financial consulting firm Oxford Economics. inflationary factors become more serious.

In a recent forecast, Deutsche Bank (Germany) assessed the risk of a “significant recession” to the US economy in late 2023 and early 2024 – a consequence of the Fed’s tightening of policy. more currency in response to record high inflation. According to Goldman Sachs, the probability of the US economy recording negative growth within the next year is about 35%.

Widespread impact on the global economy

Not only affecting the US economy, the moves of the world’s largest central bank will also affect the global economy.

One of the most notable effects is the trend of divestment from emerging economies. When interest rates rise in the US or other advanced economies, investors tend to pull money out of emerging markets and move it back to the US in search of higher returns. That would put pressure on economies that need capital to invest, while weakening local currencies. A notable example is in China – where the central bank is inclined to loosen money to stimulate growth, the capital market is facing a wave of record-high capital outflows in April. Besides geopolitical risks, the Fed’s interest rate hike is considered one of the factors driving this wave.

In response to the risk of capital flight, central banks in emerging markets can respond by raising interest rates higher. In fact, right after the Fed raised interest rates, the central banks of the Gulf countries simultaneously took the same action. Reuters reported that in countries with local currencies pegged to the dollar such as Saudi Arabia, the United Arab Emirates, Qatar and Bahrain, the basic interest rate was raised by 0.5 percentage points. And in Kuwait – where the local currency is pegged to a group of currencies, interest rates were also raised by 0.25 percentage points. However, this will also put additional pressure on the economies of countries.

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Immediately after the Fed’s move, the Central Bank of Kuwait raised interest rates by 0.25 percentage points (Source: Reuters)

Another notable effect is increased pressure on countries with high levels of public debt. In the early 1980s, the Fed raised interest rates significantly to curb inflation. For the poorer economies, which had run into loan sharks in previous years, the tightening of monetary policy in the United States and the subsequent strengthening of the dollar was too much to bear, leading to a wave of debt and crisis. bank.

A similar scenario is expected to recur, given that emerging countries’ share of both public and private debt to GDP steadily increased in the 2010s, and skyrocketed during the pandemic. Public debt ratios in middle-income economies are now at record highs, and indebtedness in the poorest countries has risen to levels similar to those seen in the 1990s.

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The Fed’s interest rate hike is expected to increase pressure on emerging countries with high public debt (Source: Reuters)

The International Monetary Fund (IMF) and the World Bank (WB) warn that many countries will need to reduce their debt or restructure their debt after public debt increased during the COVID-19 pandemic. According to the IMF, the share of bond issuers having trouble paying their bills has more than doubled, with countries such as Ukraine, Egypt and Ghana. Many countries are expected to follow in the footsteps of Sri Lanka, which defaulted on April 12.


According to Thanh Hiep

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