The Rocky Monetary Path Ahead
- The Federal Reserve is trapped between a recession and increasing inflation.
- Gradual and predictable moves to tackle inflation are the Fed’s most probable course of action.
- Bitcoin is likely to experience heightened volatility in the coming months.
Bitcoin has displayed a tight correlation with US equity markets, which, in turn, have been highly dependent on the monetary policies pursued by the Federal Reserve. Understanding the drivers and constraints of US monetary policy can provide some visibility regarding Bitcoin going forward. The tense macroeconomic and geopolitical situations means that high levels of volatility are to be expected.
As a result of the pandemic, the Federal Reserve took extreme measures, which resulted in very high levels of inflation, high stock market valuations and increasing levels of private and public debt. These outcomes entrapped the Fed between a recession and even higher levels of inflation. If it raises rates too quickly, it risks triggering a debt crisis, crashing the financial markets and endangering public finances. If it does not raise rates quickly enough, inflation will get much worse and the economy may stumble into stagflation. Its policies in the near future, therefore, will be aimed at trying to wriggle out of this trap with as little damage as possible.
In practice, this implies no drastic action and providing as much policy visibility as possible. Small, yet regular increments in the target rates, coupled with gradual tapering, are expected. This process began on 16 March when the FOMC announced an initial 25 basis-point (0.25%) raise in the target rates. Despite Jerome Powell’s comments on 21 March hinting at potentially faster hikes, the expectation is that six further increases of 25 basis points each will take place this year. Following this trajectory, the target rate would reach ~2% by the end of the year, new asset purchases would cease in March and balance sheet reductions would begin in the summer. In carrying out these policies gradually, the Federal Reserve will theoretically give companies time to adjust their debt burden and financial markets space to absorb the information.
As this process unfolds, it is likely that Bitcoin’s price will continue to be highly volatile. This is because news and data releases will trigger fear and euphoria as a result of the tense macroeconomic and geopolitical context. Negative news will imply more aggressive action by the Federal Reserve, which will force Bitcoin prices down, and vice versa. This is why the high inflation numbers released in January 2022 triggered a significant correction in both the price of Bitcoin and the equity markets. High inflation meant that the Fed would be pushed into action and uncertainty surrounding that action drove everything down. This uncertainty was then partially relieved after the FOMC raised rates by only 0.25% on 16 March. This relief, in turn, led to a market rally and a higher Bitcoin price.
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