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Investor Education

The U.S. Federal Reserve Interest Rate Hike and Balance Sheet Sell-Off

By: Sherace Pinnock, Senior Portfolio Advisor          Posted: June 23, 2022

On Wednesday, June 15, 2022, The U.S. Federal Reserve Open Market Committee raised the policy interest rate by 75 basis points (bps), moving the policy target range from 0.75-1 percent to 1.5-1.75 percent. The policy rate dictates the short-term interest rate at which large banks borrow from each other in the U.S. and is a benchmark for rates in the market. This 75-basis point hike was the sharpest rate hike since the year 1994, and it is expected that in subsequent meetings we may see 75 basis point increases again. But why is the Fed taking such drastic measures?

The Fed uses interest rate hikes as a monetary policy tool to guide the economy through sustainable growth. However, the US economy right now is facing multiple factors that threaten its macroeconomic stability. Firstly, inflation in the U.S. economy is at a level that we have not seen in decades. In May 2022, it unexpectedly accelerated to 8.6%, the highest in 41 years. This is because currently, consumer demand is outstripping supply, largely for two reasons:

Robust demand in the U.S. economy as it transitions past the peak of the pandemic, and at the same time
Reduced supply because of supply chain issues stemming from the Russia/Ukraine conflict and the resurgence of COVID-19 in China, particularly in industrial hubs such as Shanghai.
Additionally, inflation seen this year likely has roots in fiscal and monetary stimuli strategies employed by the United States Government and the Fed during the pandemic. On the fiscal side, these stimuli constituted of various relief packages that allocated in excess of 2.3 trillion US dollars to direct cash payments to citizens and other financial hardship relief measures. This included the CARES Act, the single largest relief package in U.S. history, that afforded a one-time direct cash payment of US$1,200 per person, plus US$500 per child.

On the monetary side, the Fed employed quantitative easing and repurchase operations to support financial markets and ensure sufficient liquidity by directly buying assets such as U.S. Treasuries and mortgage-backed securities to the tune of approximately 4 trillion US dollars. These actions however would have combined to significantly increase the supply of money in the economy. Typically, accelerated inflation is a by-product of increased money supply as more money in the economy tends to lead to liberal spending and capital expenditure, driving up demand and in turn, prices.

The Fed has decided to make an aggressive attempt at reducing demand through this 75bps increase in the policy rate. This increase aims to make borrowing more costly for individuals and businesses, discouraging demand and spending.

In addition to this policy rate increase, the Fed has begun to reduce the size of its balance sheet to help temper inflation as well. During the height of the pandemic, the Fed sought to support financial markets by purchasing U.S. Treasuries and mortgage-backed securities to augment the depressed demand at the time. However, that support is no longer necessary and as such the Fed will seek to reduce assets on its balance sheet at a maximum rate of around 95 billion USD per month. For context, the last period of balance sheet reduction was during 2017 to 2019, and it was at a maximum rate of around 50 billion USD per month. Shrinking the balance sheet adds even more pressure to credit markets by decreasing demand for the assets that the Fed holds, which adds upward pressure on interest rates.

At the same time, the Fed is trying to balance these measures with the possibility of a recession: the goal is to slow down the economy just enough so as to reduce inflationary pressure, but not so much that rising interest rates trigger consistent declines in economic growth. In other words, the Fed’s goal is to raise interest rates to a “neutral” level to bring the U.S. economy into a period of macroeconomic stability.

In response to the most recent Fed policy rate decision, global stocks rallied, and government bond yields retreated as markets were pleased with the Fed’s aggressive stance on the fight against inflation. Markets viewed the largely predicted 75bps-hike favourably due to the shared view that the economy is better off in the long run if the Fed is aggressive in curbing inflation now. It is expected that there will be multiple additional rate hikes at the Fed’s remaining meetings in 2022, with a credible possibility of another 75bps hike among them.