FX.co ★ Fed not to raise interest rates aggressively due to sharp decline in its balance sheet

Analysts expected that the Fed might suspend raising interest rates. However, these hopes were dashed. This caused a new wave of sell-offs in the markets on Wednesday.

Atlanta Fed President Raphael Bostick said in an exclusive interview with MarketWatch on Wednesday that his earlier suggestion that the central bank take a September "pause" in its push to raise interest rates should in no way be construed in any way as a "Fed put". It was shocking news for equity investors. Moreover, it led to a decline in stock indices.

It is unclear whether the Fed will take a "pause" in raising interest rates as inflation dynamics is a significant factor. If inflation slows down by September amid another important event that began yesterday, i.e. the reduction of the regulator's bond portfolio significantly increased during the coronavirus pandemic and Biden's stimulus measures after the elections, a "pause" is most likely. Moreover, the Fed will not damage the US economy amid the risk of recession.

The bank is expected to cut the volume of bonds and corporate mortgage-backed securities by $47.5 billion each month for the first three months. Consequently, the total amount will reach $95 billion and can be adjusted if necessary. The reduction will be made as held-to-maturity securities are removed from the portfolio and the funds received are not reinvested as it was previously. It is estimated that the Fed's balance sheet could shrink by nearly $1.5 trillion, that is to about $7.5 trillion by the end of 2023. In fact, the regulator would tighten its monetary policy again by 75-100 basis points without raising interest rates. It would amount to a key interest rate of 3.25% to 3.50%.

It would be as follows: for example, the key rate will be within the range of 2.0% to 2.5%, though in reality it will be increased to the above mentioned figures.

How would this affect the financial markets and the dollar?

It's obvious that unprecedented stimulus measures are one of the major reasons for rising inflation in the US. Therefore, a reduction in the Fed's balance sheet would limit the dollar supply in the markets. On the one hand, its demand will increase, but on the other hand the high cost of credits and their restricted availability would undermine the US economy causing a reduction in inflationary pressure. Moreover, this aspect will be favorable for Democrats like Biden ahead of US Congress elections this fall.

It is believed that experts consider political issues more significant than the economic ones to deal with. It means the Fed will definitely have to raise the interest rates until inflation ends. However, this plan can be achieved by eliminating the central bank's balance sheet. In other words, the regulator will try to lower its balance sheet, but at the same time not harm the economy. In case the Fed manages to do it, then it will take a September "pause" in raising the interest rates or may even stop raising them.

As a reduction in the balance sheet has a positive effect on bringing down inflation, then the bearish phase will end and the market sentiment will change from bearish to bullish.