Monetary Policy Toughening by the US Federal Reserve Is Unlikely to Trigger a New Wave of Financial Instability

After its two-day meeting, the US Federal Reserve released, on 16 December, its long-awaited decision that the key interest rate would be increased by 0.25 pp. – to 0.25–0.5% per annum.

This was done in response to the growth at solid rates displayed by household spending and business fixed investment in recent months, the gradual decline in the rate of unemployment in the last few years and, and the improving situation in the housing sector.

It should be reminded that the federal funds rate was reduced to near zero (0–0.25% per annum) seven years ago, in December 2008, amid the world financial and economic crisis. As the recovery of the US economy gradually proceeded, the expectations of changes in the vector of the US Federal Reserve's monetary policy strongly influenced the movement of world foreign exchange rates and stock market prices. Under these conditions, in an attempt to prevent excessive volatility in the world financial market, the US Federal Reserve, in December 2012, set a qualitative indicator or its monetary policy trend.

It was planned that, unless the unemployment rate in the USA plunged below 6.5%, the US Federal Reserve should stick to its quantitative easing policy by holding the federal funds rate at near zero. And then, although the established threshold had been passed for the first time in April 2014, when the unemployment rate dropped to 6.2% vs. 6.6% one month earlier, it was decided that the zero rate policy should be continued, and further cuts should be made to the monetary incentive programs.

In fact, the US Federal Reserve’s switchover to a tougher monetary policy was a process strictly divided into two phases. During phase one, the US Federal Reserve initiated a number of monetary incentives, which effectively put an end to its quantitative easing policy. Phase two was the raising of the key interest rate. The US Federal Reserve’s decision to halt asset purchases was announced twelve months ago, in December 2014, thus giving economic agents enough time to get adapted to the new conditions. In this connection, it must be clearly understood that the effects of the monetary policies pursued by the US Federal Reserve rebound far beyond the US economy. Firstly, the US Federal Reserve is the emitter of the global reserve currency. Secondly, the USA is the world’s second largest economy, surpassed by China only in 2014.

The risks associated with the forthcoming rise in the Federal Reserve’s key interest rate were also considerably reduced by the regular verbal interventions from its representatives, designed to convince the business community that the main financial regulator was going to increase its key interest rate only after striking a good balance between the long-term objectives envisaged in the so-called dual mandate assigned to the Federal Reserve: maximum employment and price stability (defined as a year-on-year increase in the Harmonized Index of Consumer Prices of below 2%).

We believe that, as a result of the effects of all these factors, the prices of financial and raw material assets on the eve of the December 2015 decision of the US Federal Reserve to raise its key interest rate by 0.25 percentage points had already been adjusted to the anticipated changes. However, in our view, the increase in the US Federal Reserve’s key interest rate is still likely to have some impact on financial markets, by strengthening the US dollar and, possibly, by causing a further decline in raw material prices.

Most certainly, the Russian economy will not be immune to these trends. Bearing in mind the structural specificities of the Russian economy, the greatest dangers it may face as a result of these trends are the further depreciation of the ruble that will increase inflationary risks, and the continuing decline in oil prices. It should be reminded that, over the course of 2014 and the first 11 months of 2015, the ruble lost 30% and 14.8% against the US dollar, respectively. The dollar-denominated RTS Index has also significantly declined year-on-year (by 16.6% in 2014, relative to 2013, and by 26.2% in 2015, relative to 2014). Moreover, in late 2014 and early 2015, the Russian economy was simultaneously hit by several major external shocks, unlikely to take place again at one and the same time in the near future. Therefore, it is possible to assume that the toughening of the US Federal Reserve’s monetary policy will hardly be able to trigger a new wave of financial instability in Russia.

Anna Kiyutsevskaya - Researcher