Explained: US Fed’s rate hikes, quantitative tightening and its impact on India

• The US is in a recession now, but that doesn’t seem to be the top worry for Jerome Powell, the chairman of the US Fed.
• Experts see a combination of quantitative tightening and rate hikes directing US Fed’s monetary policy for the next two years.
• However, this has shrunk the window for a soft landing, and a deeper US recession could spell “deep trouble” for India, say experts.

There has been a lot of buzz about the US Fed’s rate hikes and how the markets have reacted to them, how foreign investors have been fleeing emerging markets like India and plowing money into the US instead, but many a common man might have wondered why they should care about it.

The short answer is – the common man should care about US Fed hiking rates.

The long answer depends on how complex this is to understand, but the short of it is, economies all over the world are more connected and dependent on each other than they have been before. Given the US Dollar’s status as the world’s reserve currency, and the US being the world’s largest economy, when the US Fed sneezes, the world catches a cold.

But this time around, the US Fed sneezed after it caught a fever, thanks to its massive quantitative easing program that was resumed after Covid, resulting in it printing $5 trillion – by some estimates, this is nearly 80% of all the dollars that were in supply at the time.

The backstory: What is quantitative easing and where has it led us?

A bulk of the blame for the current quagmire goes to quantitative easing, but other geopolitical factors like the Russia-Ukraine war and the resulting sanctions drove inflation up all around the world, including the US, which is now in a recession.

To arrest inflation, the US Fed has embarked on a rate hike regime. In his commentary, Fed chair Jerome Powell hinted at the possibility of another 50-75 basis point rate hike come September, but pundits peering through Powell’s words suggest he is now leaning towards a dovish outlook.

What this means is that we may see the end of the rate hikes later this year, with rate cuts beginning some time in 2024.

While this might come as a relief to those terrified of rate hikes – after all, who doesn’t love cheap capital – there’s a bigger weapon in the US Fed's arsenal – trimming the balance sheet, aka quantitative tightening.

Is the US in recession?

A post-Covid boom was all but expected until the end of 2021 – when things started to change slowly but decisively – and the US seems to have slow-walked itself and several other developed economies into a recession.

The US is now technically in a recession, after the Q2 numbers showed the US GDP shrunk by 0.9%, after a 1.6% decline in the first three months of 2022.

There is some disagreement about whether this qualifies as a recession or not, but those are more subjective opinions and assumptions.

The popular rule of thumb is two consecutive quarters of GDP decline is a recession.

What is the US Fed doing about it?

The US Fed’s rate hikes are one of the reasons behind the slowdown in the economic activity in the US – runaway inflation print of 9.1% in June knocking down a 40-year-old record forced the Fed’s hand.

Controlling the inflation and bringing it down to 2% levels is the goal of the US Fed, and for now, a recession is not the primary worry of Powell & co.

So far, Powell has announced 225 basis point rate hikes, and experts suggest he has the stomach for 75-100 basis points more.

Possibility of a ‘soft landing’ seems marginally low now

A continuation of recession has increased the likelihood of a hard landing, say experts at Bank of America, with the window for a soft landing becoming increasingly small.

In simple terms, a soft landing refers to economic slowdown without the country going into a recession.

Since the US is technically in recession already, and Powell’s goal for now is to tame inflation, even the Fed’s flexible definition of a recession will likely not matter soon.

What is quantitative tightening and how much is the US Fed ready to do?

Quantitative tightening (QT) refers to a policy of pulling out liquidity from the markets by letting bonds and securities mature, instead of issuing new ones to replace them and maintaining liquidity in the markets.

Essentially, the US Fed bought bonds against which investors were credited money. In return, investors would have to pay interest – since these interest rates were extremely low, this was basically cheap capital available in the market.

Under QT, the US Fed sells those bonds back in the market and receives money in exchange, thereby reducing the available liquidity in the market.

The US Fed has now begun its quantitative tightening program, by slowly and steadily increasing the amount of liquidity it sucks out of markets.

Estimates peg the monthly pullback at $95 billion, totaling to nearly $2.5 trillion over the next few years. While this seems like a substantial amount, researchers suggest that even this will be “roughly equivalent” to 50 basis points worth rate hikes.

How does QT affect the common man?

While rate hikes are understood well, quantitative tightening still remains a relatively less known tool in the arsenal of central bankers around the world.

There are several factors and lots of unknowns at play here, ranging from how the US Fed oils its QT policies between aggressive and passive, how the markets respond and absorb these bonds, and just how potent QT is as a monetary policy tool.

The impact of QT is still in the nether of the unknown, and despite the best attempts by economists and central bankers around the world to understand it, its real-world impact depends on a lot of moving and uncontrollable factors.

If the US Fed manages to engineer a soft landing with the combination of QT and rate hikes, the possibility for the rest of the world to also have a soft landing increases, and that is what the common man in India should hope for. Otherwise, according to noted economist Swaminathan Iyer, a hard landing for the world would mean a hard landing for India, too, and that spells “deep trouble” for India.

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