Fed: More restrictive monetary policy not to reduce inflation – Natixis

The Federal Reserve has announced that it will exit quantitative easing by spring 2022 and then hike its key interest rates. But in the view of analysts at Natixis, what the Fed is going to do will have no effect on inflation.

What would it take for US monetary policy to really combat inflation?

“The Fed will stop increasing the size of its balance sheet and hike its key interest rates. But in the medium-term, they are expected to reach only 2 to 2.5%. Given the size of non-resident purchases of US bonds, the Fed's massive bond holdings and the modest terminal level of short-term interest rates, long-term interest rates are likely to remain low (around 2% at the end of 2022).”

“Financial markets also conclude that long-term interest rates will not rise much, real long-term interest rates will remain negative. If real short-term and long-term interest rates remain negative for several years, then monetary conditions will remain expansionary. This means that demand for goods and services will continue to be stimulated by monetary policy, which means that monetary policy is not actually fighting inflation.”

“For monetary policy to really combat inflation, real long-term interest rates would have to rise, requiring a much higher terminal value for the Fed funds rate (above 3% if we believe inflation will return to 3% in the US) and a significant reduction in the size of the Fed’s balance sheet, to steepen the yield curve.”