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The Fed Will Never Normalise Monetary Policy - Outside View by Asad Dossani
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The Fed Will Never Normalise Monetary Policy
May 4, 2017

Yesterday, the Federal Reserve held interest rates as expected. They reiterated their desire to slowly raise interest rates in the coming year. The market is pricing in a 75% probability that rates will go up in June. At first glance, it seems like easy money has reached its end. But the reality is far from this. A closer look at the Fed statement indicates just how ingrained easy money is.

Easy money consists of two things. The first is low interest rates. The second is quantitative easing, or asset purchases. Let's start with interest rates. True, interest rates have gone up twice in the last six months. And that's impressive, given historical patterns.

But rates remain at very low levels. The current Fed Funds rate is 1%. The current US inflation rate is 2.4%. This means the real interest rate is negative. The real interest rate is what you earn after adjusting for inflation. If you earn a 1% interest rate on your deposit, but prices go up by 2.4%, you are worse off. The 2.4% inflation rate is well above the Fed's 2% target. There's no reference to this in their statement.

One could argue that they have a dual mandate. Their goal is to keep inflation at 2% and ensure maximum employment. But this too falls on deaf ears. The US unemployment rate is 4.5%, the lowest it has been for 10 years.

Let's turn to quantitative easing. On this front, things are even worse. The Fed continues to reinvest proceeds from their asset purchases back into the market. And so their balance sheet remains at an astronomical level of 4.5 trillion dollars. This is five times what it was in 2008. For all the talk of rate hikes, there's been none on unwinding QE.

By any objective measure, current economic conditions do not warrant easy money. Why, then, does it persist? Like most economic policy, inertia is a powerful force. Once you are on a path, it is difficult to change. It takes courage and a willingness to push through the inevitable resistance. It is a choice between doing what is right, and doing what is easy. The Federal Reserve, for now, has chosen the easy path. Don't expect that to change anytime soon.

Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!


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Aug 22, 2017 01:11 PM