US Fed plans to slowly start making borrowing more expensive but rate hikes still a ways away

The Federal Reserve will slowly begin to wind down its bond-buying stimulus program until next summer, and then perhaps start raising its benchmark interest rate â€" maybe.

That was the main takeaway from the Federal Reserve's latest policy announcement. The U.S. central bank said it will start reducing its $120 billion US in monthly bond purchases in the coming weeks by $15 billion a month, though it reserved the right to change that pace as it sees fit, and either speed it up or slow it down.

Known as quantitative easing, the bond buying program helps stimulate the economy because it keeps yields on government bonds low. That, in turn, makes it cheaper to borrow since all kinds of consumer and business interest rates are pegged to what's happening in the bond market.

The Fed says it will reduce its pace of buying U.S. government debt from $80 billion US a month down to $70 and then $60 until it gets to zero. And it is cutting its $40 billion US in mortgage-backed securities by $5 billion US in November and December and said similar reductions "will likely be appropriate" in the following months. That suggests that the central bank might decide to accelerate its pullback in bond buying if inflation worsens.

Rate hikes could follow

If the pace is maintained, the bond purchases would end altogether in June 2022. At that point, the Fed's next logical step would be to raise its benchmark interest rate, which is its main tool to tinker with inflation.

Overall the statement was much more open to keeping stimulus in place than some other central banks around the world have been in recent weeks. Canada, for example, brought its bond buying program to an end this month, and the market thinks a rate hike could be coming here as soon as spring of next year.

The Fed statement suggests the earliest time the U.S. may raise its interest rate would be next summer â€" if not later. "There was no hint in the press statement that the end of stimulus by the middle of next year will be followed quickly by tightening via rate hikes," said Bank of Montreal economist Sal Guatieri. 

"In fact, the statement went out of its way to push back against market expectations of a mid-year rate hike," he said, noting that the U.S. being later than the rest of the world to start hiking is causing the market to "continue to question whether the Fed is making a mistake and falling behind the curve.

The changes reflect a central bank that is rapidly shifting from an effort to boost the economy and encourage more hiring to one that is increasingly focused on rising inflation.

As is the case in Canada, the U.S.inflation rate is rising at its fastest pace in decades, with prices going up at a 5.4 per cent annual pace last month.

That puts Fed officials, particularly Chair Jerome Powell, in a bind: They might want to keep their benchmark short-term interest rate at nearly zero, where it has been pegged since last March, to boost the economy, but they are facing growing pressure, including from Republican lawmakers in Congress, to rein in rising prices.

High inflation

Low rates have contributed to higher prices by making it cheap to borrow money, but supply chain problems caused by the pandemic have also exacerbated the situation.

Policy makers around the world have tried for months to argue that those factors will be temporary, but the longer high inflation sticks around, the harder it is to argue that it isn't becoming a more permanent problem.

"If [inflation] doesn't start to come down more meaningfully, you're going to have to abandon ship on saying it's transitory," said Beata Caranci, chief economist with TD Bank, in an interview.

If the Fed doesn't start raising its lending rate until almost a year from now, Canada will be in the unusual situation of having to raise its lending rate while its biggest trading partner is not doing the same.

"Time will tell which central bank is taking the right course of action," Caranci said. "My money's on the Bank of Canada â€¦ they're being a bit more prudent to the risks. They can certainly raise earlier and then decide to go at a slower pace."

The takeaway is that central banks, whether they're in Canada, the U.S. or anywhere else … are now moving to the other side of the cycle," Caranci said.

"We're not looking at interest rates that go from zero … to two per cent overnight, but we're on the other side of the cycle now where the general trend will be up."

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