The Fed is tightening its monetary policy

Raising key interest rates, future reduction in the size of its balance sheet: Art EDF began a marked strengthening of its monetary policy. For the US Federal Reserve, it is about fighting galloping inflation. However, such a policy can have negative consequences for economic activity. And it should be followed by most central banks, including ECB.

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Speeches by central bank presidents have traditionally been eagerly awaited and closely monitored by observers. Jerome Powell, Chairman of the Board of Governors of the US Federal Reserve (EDF), delivered on May 4, was no exception. During it, Jerome Powell announced a new one Strengthening US monetary policycharacterized by the following two measures:

  • Raising key interest rates, first of all, by 0.5 percentage points. Key interest rates are set by the Central Bank and are the rates at which the Central Bank provides short-term cash to financial institutions such as commercial banks;
  • Reducing the size of the balance EDF, then. In practice, the US Central Bank will stop buying securities on the financial markets from June. Thus, quantitative easing (QE) is followed by quantitative gain (QT).

Quantitative easing and size of central bank balance sheets

L ‘quantitative easing has been one of the most widely used non-traditional monetary policy measures by central banks around the world for the past twenty years. Its principle is relatively simple: the Central Bank creates central money and buys financial securities from financial institutions. This liquidity injection aims to improve financing conditions in the economy and thus stimulate the overall level of prices and economic activity.

The consequence of this policy is quantitative easing a sharp increase in the size of central bank balance sheets. The amount of assets of each bank increases with the acquisition of financial securities, and the amount of liabilities increases with entries in current accounts of financial institutions (compensation for the purchase of securities).

What are the consequences of such a tightening of monetary policy?

Strengthening its monetary policy, c EDF look first slow down prices. In fact, inflation in the United States has reached a level not seen since the early 1980s. EDF should reach an inflation rate of about 2% on average in the long run, price growth in March was 8.1% on an annual basis.

Inflation rate in the United States

Such strengthening monetary policy however, it may be accompanied by negative consequences:

  • At the domestic level, first of all: the strengthening of monetary policy could influence US government funding conditions and economic activity – which fell 0.4% in the first quarter of 2022 – in the United States and eventually led to a recession.
  • On international levelthen: developing countries and developing countries may also affect the strengthening of US monetary policy. Rising interest rates in the United States may, above all, cause a capital flight from these countries to the United States. This will force the central banks of these countries to raise their own key interest rates … at the risk of punishing their own economies. Then some developing countries can try difficulties with funding. According to the World Bank, almost a third of the external debt of the poorest countries is actually reduced at variable rates. In the context of rising interest rates, late payments may occur, similar to those recorded in Sri Lanka in April.

What about monetary policy in the eurozone?

In the euro area, inflation has also been returning for several months. According to Eurostat, in March price growth reached 7.4% year on year. In this context, the European Central Bank (ECB) has already announced a reduction in the purchase of securities on the financial markets in the coming months. However, for now, the European institution has decided not to raise its key interest rates, unlike most other central banks. At the moment, such a decision seems inevitable and should be announced by the summer.