Monetary Policy Divergence – What Does It Mean?

Monetary Policy Divergence – What Does It Mean?

The Federal Reserve last week hiked its target interest rate another quarter-point, to 1.0-1.25%. But the world’s other major central banks, the Bank of Japan (BOJ), Bank of England (BOE), and the European Central Bank (ECB), have kept their ultra-low interest rate targets intact. This monetary policy divergence means that the United States is now tightening monetary policy while the other major developed nations are maintaining ultra-loose monetary policy stances. What effects does this have on savings and investment for Americans?

Despite Tightening, Monetary Policy Is Still Loose

Even though the Fed has moved away from its unprecedentedly loose monetary policy, monetary policy is still quite accommodative. Interest rates around 1% are still abnormally low, and the Fed’s balance sheet is still unusually high, at nearly $4.5 trillion. Even though the Fed has indicated that it intends to begin reducing the size of its balance sheet this year, nothing is set in stone. Should economic conditions begin to worsen, the Fed may very well postpone further rate hikes or the date on which it plans to begin drawing down the balance sheet.

Furthermore, the Fed’s plan to reduce the size of the balance sheet will be long and drawn out. Because of the various maturity dates of the securities held by the Fed, it has decided not to allow its holdings simply to expire. That would mean that in some years hundreds of billions of dollars worth of securities would mature, while in other years almost none would mature. Instead, the Fed is planning an orderly decrease in the size of its balance sheet.

The maximum amount of reduction in the balance sheet will be around $50 billion per month, and there may very well be months in which the Fed doesn’t reach that figure. At that rate, a “normal” balance sheet that will still be twice as large as the Fed’s pre-crisis balance sheet won’t be reached until at least 2020.

Pressure to Maintain Loose Policy

Some Fed policymakers, among them the Chicago Fed’s Charles Evans and the Minneapolis Fed’s Neel Kashkari, favor maintaining a looser monetary policy stance. Kashkari voted last week against the Fed’s rate hike.

Markets may also rebel against the Fed’s tightening of monetary policy, which could cause the Fed to pause its tightening. If you remember the “Taper Tantrum” back in 2013, just imagine that happening on an even larger scale. Financial markets have gotten used to cheap money from the Fed and they don’t want to see their gravy train coming to an end. And since the Fed is deathly afraid of doing something that will hurt financial markets, it may very decide to backtrack on or delay any further tightening.

Monetary Policy Actions as Signals

Because the BOJ, BOE, and ECB have all maintained their monetary policy target rates while the Fed has begun to tighten, the Fed’s actions could be seen as a sign of signaling. Just like with airlines that hike or cut ticket prices to see how other companies respond, the Fed could be hiking rates to see how its counterparts in other countries respond. If the other central banks decide to start tightening this year too, then the Fed will have a green light to continue. If, however, those other central banks don’t tighten, then the Fed faces a predicament. If it continues to tighten, the dollar will strengthen and become more expensive, favoring foreign exporters over American exporters. That would lead to political pressure on the Fed to end the tightening or to restart easing in order to assist American export industries.

It could also lead to continued accusations against foreign central banks that they are engaged in currency manipulation, a threat that both the Obama and Trump Administrations have attempted to use as a bargaining chip in international trade negotiations. The Fed’s actions don’t occur in a vacuum, and the international ramifications are real.

For precious metals investors, the tightening in the United States will likely pop the incipient bubble that is developing and hasten the next recession. As stock and bond markets begin to deteriorate, gold demand will increase and gold’s price will rise. Investors who have staked out solid positions in gold and silver will stand to make strong gains.