Although Fed Chairman Powell made it clear at a recent hearing that he would give the timing of the decision to reduce the balance sheet, Gu Chaoming, chief economist of Nomura Securities, believes that the Fed will not only reduce the balance sheet, but also have a faster pace than planned.
The latest data show that the U.S. CPI rose 7.0% year-on-year in December, and the growth rate accelerated again, the fastest increase since June 1982.
Inflation has also driven wages up. On Jan. 12, EST, in the economic survey report "The Beige Book," the Fed said some regions highlighted additional growth in labor costs associated with non-wage benefits. Reports in many regions indicate particularly strong wage growth for low-skilled workers, with compensation growth well above historical averages across industries, groups of workers and regions.
At the FOMC meeting late last year, the Fed officially announced speeding up tapers. Powell said the Fed is already on track to end taper (code reduction QE) in mid-March 2022 and will be months ahead of previous plans.
The Fed has previously made it clear that monetary policy normalization can only begin when economic conditions meet two conditions – inflation above 2% and maximum employment levels.
But in terms of employment, the U.S. unemployment rate was 3.9 percent in December, with 6.319 million unemployed, up 602,000 from 5,717,000 in February 2020; the unemployment rate in February 2020 was 3.5 percent, when inflation was significantly lower.
The data suggests that it is still controversial whether the U.S. economy has reached its maximum employment level, which may be why the Fed decided to continue its QE and zero-interest rate policies for the time being.
Gu Chaoming elaborated from the perspective of inflation drivers, the difference between this policy change and 2015, and the rhythm of this round of quantitative tightening, believing that the Fed, as a staunch "inflation fighter", should not only reduce the balance sheet according to Powell's statement at the same time as the policy change, but even accelerate the pace of the balance sheet reduction.
The Fed underestimated the level of inflation driven by supply shortages
Gu Chaoming believes that the Fed needs to speed up the pace of balance sheet reduction, and a very important reason is that the Fed, economists and even the market have underestimated the level of inflation caused by supply chain chaos.
Powell argues that outbreaks are just a "natural disaster," but natural disasters usually only occur in specific geographic areas and do not cause serious harm to other areas.
This time, however, the world has been hit by the pandemic, making it more difficult to diversify or replace production.
Supply chain pressures have plagued U.S. ports with congestion for months: The number of container ships waiting for berths at the ports of Los Angeles and Long Beach is now at a record high of 105, while vessels waiting at other ports have also reached a new high, with 146 waiting berths on the three major U.S. coastlines overall; and cargo arriving at U.S. ports is about 20 percent higher than the record set in 2019.
In its Beige Book, the Fed notes that while the shortage of commodities caused by the supply problem is gradually being resolved, it is not expected to be completely resolved in the short term; as the Omilon strain continues to spread, the situation may worsen in the short term.
In the midst of this strong uncertainty, coupled with considerations of the recent strength of inflation, Koo believes that the Fed will raise interest rates at least once after ending QE in March.
Fed officials and market participants expect rate hikes of 3 to 4 times, 25 basis points each, in 2022. Regardless of how the Fed responds to inflation, Gu noted, "we need to remember that recent inflation has been largely driven by supply-side factors." ”
Powell suddenly turned eagle the market was skeptical
Just six months ago, Powell was adamant in his assertion that inflation was only "temporary."
But at a Senate hearing on Jan. 11, Powell announced that the Fed could begin clearing liquidity as early as the second half of 2022 after the first rate hike — a process known as quantitative tightening (QT).
For the Fed, which is currently implementing quantitative easing, it is highly unusual to hint that it may act in the exact opposite in a few months.
Gu Chaoming believes that the sudden change of attitude not only shows that the Fed is actually very worried about inflation, but also aims to establish the image of the Fed as an "inflation fighter".
If current inflation is caused by excessive demand, then raising interest rates would be a very effective move. But once the supply problem is resolved, current inflation expectations fade, and central banks may want to avoid a "sharp increase in policy rates followed by another rate cut."
If market participants believe the Fed is lagging behind in terms of inflation, they may start dumping bonds to protect themselves from inflation, pushing long-term interest rates higher.
If the Fed's lofty image as an "inflation fighter" is destroyed in this way, long-term interest rates could soar, destroying the economy before prices stabilize; it will take a lot of time and more effort to restore market confidence and pull long-term interest rates lower.
Based on this, Gu Pointed out that the Fed believes that the best way is to control long-term interest rates. The Fed needs to underscore its determination to fight inflation and take a hawkish stance as early as possible to prevent this from happening.
For the Fed to re-establish itself as an "inflation fighter," it needs not only to raise interest rates, but also to announce its readiness to begin cleaning up excess liquidity in a relatively short period of time (which means speeding up the pace of balance sheet reduction). Normalization of monetary policy, then, means a contraction in bank reserves.
Liquidity needs to be cleaned up faster to control credit creation in the private sector
From the perspective of asset prices, the surge in real estate prices has also accelerated the process of normalization of monetary policy.
U.S. commercial real estate prices are already 65 percent higher than previous all-time highs, and residential property prices are 48 percent higher than the last bubble-era highs. Gu Chaoming believes that this highlights the bubble nature of the current market.
In addition to recent inflation, which has been largely attributed to supply-side bottlenecks, the Fed has been criticized for "lagging behind the curve" in terms of overall prices and asset prices.
Gu pointed out that, as Powell acknowledged, this means that the road to monetary policy normalization will be long. According to the schedule released by then-Fed Chairman Yellen in June 2017, in the last QT phase, the Fed planned to absorb all excess reserves in 45 months – or less than 4 years. But this time, assuming QT starts in April 2022 and proceeds at the same rate, it will take 6 years and 8 months to absorb all the excess reserves, a process that will end in December 2028.
Gu Chaoming believes that it is obviously unacceptable to spend six and a half years normalizing monetary policy when the inflation rate has reached 7%. That means the Fed may have to shrink its balance sheet faster and increase the amount of reserves it absorbs each month.
At the same time, the demand for funding from the private sector is intensifying.
U.S. money flow data shows that the U.S. private sector has maintained a huge financial surplus through the third quarter of 2021, but recent bank lending data shows that this is changing: Bank lending has been growing at an annualized rate of 10.6% since october last year.
In the case of high inflation, excess reserves cannot remain in the banking system because they lead to endless lending.
If this major trend does exist, it means that inflation could accelerate from this source, something the Fed needs to keep a close eye on. Under quantitative easing, the excess reserves capable of financing loans have soared from $1.8 billion when Lehman Brothers went bankrupt to about $4 trillion today.
While the current rising inflation is largely attributed to supply-side bottlenecks, a significant increase in bank lending will increase the money supply, which could spur an acceleration of inflation from the demand side.
It is very different from 2015 The Fed's careful preparation has also avoided market chaos
In December 2015, after the U.S. unemployment rate fell to 5.0 percent (considered fairly low at the time), the Fed began raising interest rates despite inflation well below its 2 percent target.
In October 2017, after the policy rate was raised above 1%, providing the market with an adequate "shock absorber", the Fed officially began QT, with a 1 year and 10 months of preparation in between.
From then until the first half of 2019, the Fed raised interest rates a total of nine times.
The Fed gave this 22-month lead time because, as the world's first central bank to end a large-scale quantitative easing program, the Fed wants to create a financial environment that can absorb any risks that may arise.
But at that point, expectations of quantitative tightening of the Fed triggered a "taper tantrum" in the bond market, sending long-term U.S. interest rates soaring, triggering a new round of market turmoil that eventually took nearly a year to stabilize.
The Fed's monetary base was about $3.9 trillion when it last implemented QT, but this time it's close to $6.5 trillion, about 1.5 times the last time.
Meanwhile, inflation has remained below 2 percent throughout the last QT, while inflation in the U.S. has now soared to 7 percent; the unemployment rate was 5.0 percent in the last QT period, and this time it has fallen to 3.9 percent.
The fiscal stimulus this time was so large that a key Democrat and former U.S. Treasury Secretary Lawrence Summers also issued a warning about inflation. In addition to the stimulus package already in place, the Biden administration intends to introduce a further $1.7 trillion stimulus package, the Build Back Better bill, which was vetoed late last year by Democratic Senator Joe Manchin.
Gu Chaoming believes that in view of these obvious differences in the economic environment from now to 2015, the process of normalization of monetary policy will have to be implemented as soon as possible. Before the Fed officially starts raising rates, it doesn't have time to create a so-called market "shock absorber" as it did before; Powell also said that the Fed will consider launching the QT process immediately after the first rate hike. This suggests that the Fed is unlikely to wait 20 months like it did last time.
This time QT, not only is the economic environment very different from that of 2015, but the Fed has also made careful preparations:
In November, the Fed announced a reduction in purchases of $10 billion in U.S. Treasury bonds and $5 billion in institutional residential mortgage-backed securities (MBS) each month.
In December, taper's pace accelerated further: the Fed announced a reduction in purchases of $20 billion in U.S. Treasuries and $10 billion in institutional residential mortgage-backed securities (MBS) each month.
Gu Chaoming believes that this relatively "cautious" rhythm has achieved results and avoided big market chaos. This time, there is absolutely no need to continue to implement quantitative easing because of sufficient or excessive fiscal stimulus measures. In theory, it should end as soon as possible.
As mentioned above, for various reasons mentioned above, Gu Chaoming pointed out that this time the process of normalization of monetary policy must be implemented very carefully and must be completed at a faster speed. But what the situation today and 2015 has in common is that the Fed is still the first major central bank to normalize monetary policy, ahead of the Bank of Japan and the European Central Bank.
This article is from Wall Street Insights, welcome to download the APP to see more