As the economy goes through what are hopefully the last bits of COVID-19, the Federal Reserve, the country’s main monetary institution, has taken the first step towards normalcy. For years, the Fed had bought bonds and other bank securities of varying levels as a method of quantitative easing to increase asset liquidity in the economy, as well as to create an environment for cheaper borrowing.
Bond purchases total $ 8.5 trillion on the Fed’s balance sheets, with the reserve buying about $ 120 million in bonds each month. This reduction in buying comes as the US economy rebounds from the pandemic, and with interest rates low, this move could also serve as a controller for inflation which is now expected at 4.2%. Even if there is no interest rate hike expected for this year, 2023 could see debtor rates at 0.6%.
With high inflation, a drop in bond liquidity, while interest rates are low but with the premise of increasing, economists worry about another “Jimmy Carter stagflation,” this time a “Joe Biden stagflation,” as Art Laffer, former economic adviser to President Reagan, called him.
Robert Mayo, professor of economics at Concordia and expert in microeconomics, says: “Money does not mean wealth. Money is a measure of wealth.
Whether this decision may have been made because of the Fed’s concerns that current inflation is not transient, he says, depends on your definition of transient.
“There are three reasons: either they think monetary stimulus is no longer necessary, or they think the risk of causing inflation is too high,” Mayo explains. “A third reason could be that the combination of high government spending and quantitative easing can drive inflation to the moon.”
The Bureau of Labor Statistics reports that the August 2021 consumer price index (CPI) rose to 5.3%, while energy prices rose to 25%. The average consumer might think that the opportunity cost of higher economic growth might be higher prices, but this does not appear to be the case.
Bank of America economists to predict the US economy will slow in the third quarter due to inflation and shortages, which is typical of an economy close to stagflation.
“Some economic engines of growth and inflation are reminiscent of conditions in the 1970s,” Mayo said. “However, if you want to be sure, consult your local crystal ball.”
Angel Rodriguez, professor of finance at Concordia, predicted a short-term housing market slowdown due to the Fed cut.
“With higher interest rates and fewer mortgages bought by the Fed, banks are less likely to grant loans and as a result the market cools,” Rodriguez said. “In the long run, house prices will go down if the Fed continues to withdraw support.”
Regarding the risk of inflation, Rodriguez explains that in addition to injecting more money into the economy, the purchase of assets did not cause inflation. For him, the slowdown in economic growth is attributed to COVID events, so it’s still not clear if potential stagflation is around.
Riaz Aziz, professor of economics and corporate finance at North Dakota State University and Concordia, shares a different idea about the Fed’s decision to cut back on asset purchases:
“The Fed are mandated by Congress for two main reasons: unemployment and controlling inflation,” Aziz explains. “In an era of low interest rates, borrowing is already cheap and injecting money into the economy wouldn’t be necessary. “
Additionally, Aziz reaffirms his view that current inflation is transient and purely non-fiscal. Mortgage-backed securities, however, may experience some shortfall in demand, at a time when demand is declining as investors sell more of their bonds and yields rise. What will happen next can only be proven by time.