INSIGHTS

The highlight of the coming days - for economists and finance junkies, that is - will be the outcome of the Federal Reserve meeting in the US.

The Fed is the world’s largest and most influential central bank, so its policy settings have ramifications for interest rates, currencies and sharemarkets everywhere.

Like most of its peers (including our own Reserve Bank), the Fed slashed its main policy interest rate to almost zero in the wake of last year’s pandemic.

It also embarked on a bond-buying programme (more commonly known as quantitative easing, or QE) to provide even more support to financial markets, to the tune of US$120 billion a month.

While the US economy has recovered from the worst of the pandemic, economists are now speculating on when the Fed will begin to withdraw some of this stimulus, and what effect it might have on financial markets.

America has rebounded strongly from last year’s weakness, corporate earnings growth has been very strong, and the sharemarket is more than 30 per cent above its pre-pandemic high.

Inflationary pressures have also been rising in recent months, with core inflation hitting an annual rate of 4.5 per cent in June. That was the highest since 1991.

Some of that increase will prove transitory, with many goods and services having increased in price due to pandemic-related shortages and supply chain blockages.

As these issues subside, we should see the inflation rate fall back to more modest levels, although it could still settle above the Fed’s two per cent target.

Even if that’s the case, inflation isn’t its only focus any more. These days the Fed has a dual mandate - ensuring stable prices over the medium term, but also achieving maximum employment.

While it looks to have met the inflation objective, the labour market still has a way to go.

The headline US unemployment rate is currently 5.4 per cent, well below last year’s 14.8 per cent peak but still quite a bit higher than the 3.5 per cent that prevailed just before the pandemic hit.

Fed Chair Jerome Powell has pointed out that this reported rate understates the amount of labour market slack, and that the true unemployment rate could be closer to eight per cent.

Because of this, Powell has said that even though the Fed could begin paring back its bond-buying programme this year, it won’t be in any rush to raise its policy interest rate after that. In fact, the Fed’s own forecasts this won’t increase until 2023.

However, any reduction (or tapering, as is the financial jargon) of the bond-buying programme will still be viewed as a move to start weaning financial markets off this liquidity and support.

When that happens, it could push interest rates and the US dollar a little higher, while it might create a bit of tension across global sharemarkets as investors come to grips with the reduction in liquidity.

I’ll be surprised if we see the Fed make any tapering announcement this week, but there’s a decent chance we get one before the year is out.

That won’t spell the end of the recovery (or necessarily curtail the market’s strong run) but it will mark an important turning point for monetary policy around the world.