By Sabrina Wong
The Fed has announced that it will put interest rate hikes on hold between 2.25% and 2.5% and has hinted at the possibility of slashing rates before the end of the year, citing poor economic indicators and widespread uncertainty as drivers behind these decisions. The US economic picture is made even more unclear by the recent unprecedented 35-day government shutdown causing a lag in the availability of the most updated data. Global trade tensions have increased as a result of political systems continuously failing to reach trade agreements—creating, in turn, heightened market volatility. Finally, political and economic confusion surrounding the future of Brexit has made it difficult for investors to react with confidence.
The US central bank also put plans in motion to halt the shrinking of its $4 trillion asset portfolio this September. The Fed’s holdings currently consist mostly of trillions of dollars worth of long-term Treasury bonds and mortgage-backed securities that were bought during the Great Recession to spur growth.
The Fed is now at a crossroads; there is much ambiguity in terms of how the portfolio’s composition should be shifted. Some Fed officials have pushed for the replacement of long-term treasuries with short-term notes. In the event of an economic downturn, this would create more room for the Fed to stimulate growth through quantitative easing activities, which entails buying up long-term securities to incentivize investors to buy riskier assets like equities. However, holding mostly short-term notes is not conducive to economic stimulus. In the event that the current economy is actually headed towards a sustained decline, such a tightening of monetary policy in this scenario can exacerbate the situation.
Another option that is gaining more headway is maintaining a diversified mix of securities, with the composition of maturities set in proportion to the actual Treasury market. The general consensus is to hold the mortgage-backed securities to maturity rather than selling them—to prevent rattling the already delicate housing market. Investors will be closely monitoring the Fed’s activities moving forward, as they will greatly affect the economic climate.
Many experts are predicting the next recession to occur in 2020 or 2021. Perhaps the most ominous indicator is the very recent development of an inverted yield curve. This is a significant warning because it implies that bond investors expect interest rates to be lower in the future than the rate at which the Fed has currently set them. An inverted yield curve indicates that investors expect more short-term risk and are worried about the near economic future.
Presently, the central issue at hand is that the Fed must make trade-offs between shifting from long-term bills to short-term Treasury notes in order to have enough room to drive rates down while simultaneously avoiding setting off a downturn in the first place by tightening the money market too quickly through these purchases. In a world of unprecedented uncertainty, the Fed is faced with the extremely difficult task of predicting the future in order to apply the most appropriate monetary policy.