After seven years of zero–interest rate policy, the Federal Reserve initiated a series of interest rate increases by raising the federal funds rate by a quarter of a percent in December 2015, which they repeated in December 2016. In 2017, the Fed increased the rate three times, each by a quarter of a percent, and this year, the rate has been raised twice, with two more anticipated increases.
At the same time, the Fed, in October 2017, started contracting its $4.5 trillion balance sheet and intends to reduce it by $50 billion per month.
Time and again, we have seen evidence that the US economy is beyond the Fed’s control. We are also witnessing that, in their attempt to reign in control via credit market interventions, the Fed is in fact forcing the economy to shudder and shrink.
As a result of the funds rate increases and the balance sheet reductions, the Fed is effectively extracting the liquidity that has raised the stock market indices far beyond what could be expected. This is the same liquidity that has boosted residential real estate prices beyond their 2006 levels. We’ll have to wait and see what will happen to these extreme asset prices once the liquidity retreats.
Inevitably, the US economy will shrink. Fed chairman Jerome Powell is raising the federal funds rate to allow him to later decrease it when the economy recedes. The reasons behind reducing the balance sheet is similar—it allows Powell to increase it when the yield curve inverts (see our article about it here), and the big banks are in need of another huge bailout.