The US Central Bank recalibrated its outlook on the recovering US economy last week and the appropriation sent the world markets into activity. The Federal Reserve insinuated a possible hike in the interest rates in 2023; a sharp turn from the earlier announcement of keeping the rates stable till at least 2024. While the implementation still falls 2 years ahead, the unexpected insight and such a speedy change of perspective added weight to the voices behind the warnings of an over-heated US economy in a post-pandemic world. The Fed Chair Jay Powell had earlier sated the worrisome elements back in March when the Federal Reserve decided to keep the interest rates low in the short-run whilst conducting heavy Open Market Operations (OMO) to keep the yields low and subsequently, keep the financial markets and investment activity stimulated. However, many economists predicted a sharp recovery in the second quarter of 2021 and warned the investors regarding the inflationary pressures that could follow in a scenario where the US economy outperformed the expectations of the Fed.
The scenario appears to be shaping well as the inflationary figures started hitting highs in April. The US inflation rate stood as high as 5% in May – way above the 2% targeted inflation – yet the Fed continues to stimulate the economy that is already running and bustling. The result could be a devastating spiral of inflationary pressures that the economy has not witnessed shortly. Coupled with a stagnant supply, the forthcoming years could turn the dovish sentiments into an inflationary nightmare that could only be avoided through a relatively tighter monetary policy.
Ridding the wave of the generous stimulus packages, the US economy was touted to pull back the country from the throes of the pandemic. The recent $1.9 trillion package balanced the mayhem that was all but wrecking the financial nucleus of the United States. The businesses were stabilized, the unemployment rates contracted, and the demand rebounded strongly. However, the ambition was to reconstruct the battered economy to the pre-pandemic levels as soon as possible. The vision could only be achieved by financing the investments and continuing to stimulate the demand and collateralize the supply until it was self-sufficient. The latter never happened. While the Fed succeeded in keeping the yields low via Asset Purchases worth $120 billion per month, the US supply faced the brunt of the intermittent lockdowns in major states. A fully equipped population and scarce resources added the pressure that is now renditioned in the form of an inflationary pressure showing signs of deterioration.
Due to hefty healthcare packages and prodigal unemployment benefits, the US industrial output has suffered the brunt of a stagnant labor supply. The basic tents of economics explain the inflationary pressures that have worried the Fed. Yet, a timely policy change is crucial in other aspects as well. As the global economy is improving, so is competitiveness. With an overheated US economy and stunted industrial growth, the US exchequer is facing the might of the post-pandemic market. The US Current Account deficit, which stood at a colossal figure of $647.2 billion in 2020, worsened further as the Fed continued to purchase assets and added more to the fall in the real value of the US dollar. The Current Account deficit broadened by $74.4 billion in just the first quarter of 2021. The deficit currently stands at the worst level since the financial crisis struck in 2007-2008.
With continually expanding imports and over-reliance on international capital, the US dollar has lost its charm since March last year. The US dollar fell by about 12% against a basket of major currencies in the world. Coupled with a negative savings sentiment in the United States and a broadening Budget deficit due to lofty stimulus packages, the US economy runs a major threat of driving down the US dollar further, adding more expense to the imports and thereby expanding the Current Account deficit further despite already being the highest deficit today in the world.
Safe to say, the hint of a tightening monetary policy was served to correct the spiral of another bout of devaluation and put a stop to the overly stimulated economy. The investors expected the Fed to pull the plug on the Asset Purchase Program that has kept the Treasury Yields close to 0. While the Fed is not planning to cut the purchase for another couple of months, the mere insinuation of an earlier than expected termination led to a sell-off in the US Treasury market, pushing the 10-year yield to as high as 1.51% while boasting the 30-year yield to just over 2.0%. The correcting also activated the global oil markets as Brent and WTI converged as close as $75/barrel. Moreover, the US dollar gained value on the back of a strict monetary policy as the Dollar Index spiked 1.03% in just 2 days following the Fed’s insight.
The American economy no longer hangs on the brink of a double-dip recession. And although the economy is no longer inflicted with the curbs of the pandemic, the economy is still demand-active. Thus, the savings-short economy is still heavily reliant on the monetary assistance of the Federal Reserve. With a looming inflationary spiral, an active vaccination drive, and a weakening dollar, now is the chance of ceasing the excess liquidity and shifting to a hawkish policy to gauge the gears of a self-reliant yet a controlled economic progression in the forthcoming years.
