The U.S. Federal Reserve started 2022 with an optimistic – though unorthodox – choice. A few days before the last bell of 2021, they announced a new package of policies that will alter its monetary policy for years to come. These new measures are meant to help the country transition out of the emergency measures of the last two years.
As it stands, all eyes are on the U.S.'s macroeconomic performance. Although many of the policies chosen by the Federal Reserve are in line with international and expert recommendations, there is still some degree of uncertainty. Ongoing inflation and increased government debt could derail this new recovery plan.
Is it Safe to Come out of "Emergency Mode"?
The Federal Reserve's emergency lending program was initially established in the last quarter of 2020. It was part of a broader effort meant to "protect Main Street" from the generalized economic disarray brought by the COVID-19 pandemic.
This program included many measures similar to those implemented during the 2007-2008 financial crisis. It provided the Federal Reserve with the means to provide emergency loans to financial institutions. This time around, however, these powers were extended to target mid-sized and small businesses rather than just large banks. It also allowed the Reserve to buy many long-dated assets and keep nominal interest rates very close to zero.
These measures will be phased out progressively. First, the Federal Reserve will begin buying fewer long-dated assets and cease its involvement in other buyback programs. At the same time, they will slowly increase the minimal interest rate. By 2024, the policy rate should hit 2.1% and continue increasing.
For the beginning of 2022, the worst of the pandemic now seems to be behind us. Last year ended with many promising signs of recovery, particularly regarding wages and employment. The economy's progressive reopening has driven unemployment down, and it is now 4.2% below its pre-pandemic level.
For the Government and Investors Alike, Inflation is the Biggest Threat
But not all economic prospects are equally rosy. In particular, inflation levels remain concerning: it went up by 6.8% in the last quarter alone, prompting what has been called "the first major inflation threat in a generation."
Several domestic and international analysts have pointed out that long-term inflation will define economic outlooks for the coming decade. This prompted a new set of warnings regarding the Federal Reserve's rate increases, as they may not be aggressive enough to compensate for inflation.
For example, the expected real interest rate for 2024 is expected to be negative by four to five points – and this projection takes current inflation as a guideline. Currently, stakeholders worldwide expect inflation to rise further, driven by the government's debt-to-GDP ratio and the increasing cost of housing and basic foodstuff.
Market Performance: Expectations versus Reality
By keeping rate increases modest, the Federal Reserve is making a bold gamble on the future: it wants investors and bond-holders to understand that it expects inflation to go down, making real inflation follow.
Economics is equally a mathematical field as it is a social science. It is often driven or transformed by people's expectations and their level of trust in the future. Historically, widespread panic has triggered famous crashes, so it makes sense that personal optimism can also push recovery. Likewise, a market that expects inflation can create further inflation: large increases in the policy interest rate can trickle down into pricing decisions for consumer goods, wage negotiations, and even personal purchases.
But what happens if the Federal Reserve's confidence proves to be misplaced? If another significant world crisis (such as an international conflict) arises, optimism will be seen as misguided. This could potentially undermine investors' trust in the Reserve itself, and this dip in reputation may be hard to counter.
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