When the Fed announces the start of taper this week, monthly securities purchases will likely drop by $15 billion initially from the current $120 billion. By summer of next year, they could be cut back to zero altogether. Until then, however, the central bank's balance sheet will continue to grow, reaching a volume of more than $9 trillion - about ten times as much as in 2008 and more than twice as much as before the Corona pandemic. The numbers show that these initial steps toward monetary tightening do not alter the fundamentally expansionary stance of monetary policy.
In the course of the coming year, the Fed is likely to raise the key interest rate again for the first time, which it had cut drastically from 1.75 percent to 0.25 percent in March 2020. The markets' current expectation that there will be two interest rate hikes at once is understandable in light of persistently high and rising inflation rates. Fed representatives have also recently expressed doubts that the higher inflation is really only temporary, as has been communicated so far. However, a double rate hike in 2022 is not necessarily to be expected. After all, the Fed is making the decision on the key interest rate dependent not only on the inflation trend, but also on the return to full employment. That implies an unemployment rate below 4 percent, labor market participation roughly on par with the early 2020s, and wage growth picking up noticeably regardless of pandemic-related distortions currently still evident in the labor market. While it is quite possible that all of these conditions will be met as early as next year, it is not very likely.
The fact that the Fed is already providing arguments in this precautionary way that suggest a rather cautious exit from the ultra-expansive monetary policy is not only due to its mandate, which unlike that of the ECB also explicitly includes the goal of full employment, but also to an unnamed factor: at the latest with the Corona crisis, the central banks have established a new monetary policy regime that does not exclude the more or less open financing of the states. With debt growing to more than 130 percent of GDP in the wake of the Corona crisis, this factor is gaining weight because rising interest rates could very quickly push the American government's ability to act to the limits and shake general confidence in the country's debt sustainability. In addition, the ongoing political debate in Congress does not suggest that any serious action will be taken to limit the debt. On the contrary: because the Democrats want to further increase spending, but the Republicans are against any form of tax increases, a further increase in the mountain of debt is the most likely scenario.
The Fed will (have to) take this into account, but this puts it in a dilemma: a slow path of interest rate hikes might not be enough to contain inflation, and high inflation rates could in turn push up long-term interest rates, which so far have not been directly controlled by the Fed. A scenario in which the Fed could switch to controlling long-term interest rates in the medium term - along the lines of the Japanese model - thus remains conceivable. The result of a monetary policy that has created enormous liquidity in past crises and does not cut back on it even in an upswing would be systemically high inflation, which citizens, companies, analysts and market participants alike should be prepared for.