By Carjuan Cruz

Investing.com — Although the 2022 year started with a second wave of Covid-19 patients, the Omicron variant was more infectious. However, markets seem to have confidence that there will be minimal impact on the economy.

It is unlikely there will be any reversal of the US Federal Reserve’s policies regarding tapering and three possible interest rate increases during the year. However, there remain concerns about the rise in infection, particularly due to labor shortages.

The tapering reduction, although now more aggressive, means that there will be a decrease in the amount of liquidity. This was largely due to the dramatic increase in money supply during the pandemic. Along with the potential for a lower monetary stimulus, there will be an increase in interest rates.

José Gonzales, managing partner of GCG Advisors, a financial advisory firm based in New York, explains to Investing.com what the immediate effects on the economy could be, especially on the financial system and consumption.

Investing.comWhat might be the effects of an accelerated taper?

José GonzalesThe financial markets don’t seem to exist in the first place. Although there is some volatility in trading activity of commodities, cryptos and stocks over the course of the day, this does not seem unusual given the low liquidity at the end the year. Markets appear to be trying to ignore what a drop in monetary liquidity would mean for them. Instead, they continue to achieve record highs.

However, the effect might be one of “momentum”, in that the decrease in liquidity should have an effect on what Thomas Hoenig (ex-President of the Federal Reserve of Kansas) calls the “allocative impact” which is the amount of resources placed in assets under “zero rate” conditions creating “asset inflation”, also known as “bubbles”.

ICComment will the economic impact of this drop in liquidity?

JGWe already see it in volatile financial assets and pressure on interest rates. It also affects commodity prices. The strengthening of the dollar may reduce inflationary pressure if the Fed’s tightening strategy works.

This will not be possible if liquidity is reduced, but it also depends on the solution of logistics problems that plague supply chain supply chains and have put upward pressure on supply side inflation. The pandemic caused a shift in demand from goods to services, which has further complicated the situation.

ICWhat could this mean for the financial system?

JG: It will depend on the size and strength of the balance sheet of each financial institution, since a reduction in liquidity and an increase in interest rates tends to favor financial intermediation as long as the banking assets remain as such and are not affected by their deterioration vis-à-vis their liabilities.

The banks of the United States and other developed countries, as well as those from emerging economies like China, are generally solid and shouldn’t have any major issues. However, this might not hold true for countries that have current balance problems or are exposed to consumer credit.

The Fed created an indemnity mechanism to compensate banks in the United States. This is in the event that quantitative easing reductions are accompanied with substantial increases in repo (repurchase agreements) operations.

ICWhat if supply is rising?

JG: While this is certainly a concern, it has been determined by the Fed, Bank of England, and ECB that inflation is not considered “transitory” and that there is a need to reduce monetary assistance and raise interest rates to combat it.

People’s Bank of China (the only large central bank to do the opposite) is actually lowering rates. But, China’s freedom in economic policy decisions is unlike anything in the West.

ICWhat if the March rate increase is followed by the two additional rate increases later in the year? Will there be positive or negative consequences?

JG: This positive, undoubtedly, reduces inflationary pressure resulting from the rise in liquidity resulting aus monetary fiscal assistance. However, the most serious risk to the post Covid economic recovery is that it could affect financial markets which have served as an indicator and incentive for corporate confidence during the pandemic.

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