The Federal Reserve building is pictured March 18, 2008 in Washington. REUTERS/Jason Reed/File Photo
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NEW YORK, Aug 15 (Reuters) – Given the recent slowdown in inflation, the Federal Reserve is baffled ahead of plans next month to double the rate at which it is shrinking its massive $8.9 trillion balance sheet.
The Accelerated Quantitative Tightening (QT) move, as it’s called, is designed to further drain the pandemic-era stimulus from the financial system and raise lending rates on long-term assets to ease inflation. But that’s happening as the US Federal Reserve rushes to raise interest rates to tame stubbornly high inflation, which is currently more than three times the Fed’s 2% target.
But the double tightening makes it harder for the Fed to achieve a “soft landing,” where the economy slows but avoids a recession. With some investors believing the economy is already in recession, speculation has mounted that something is bound to give way, it could be the pace at which QT is unfolding. However, the likelihood of the Fed changing its plan in the near term remains high, some bond investors say.
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“There is some leeway for the Fed to either advance quantitative tightening slowly or even end it earlier than expected. But it’s hard to know (how) the Fed is balancing things,” Yung-Yu Ma said. Chief Investment Strategist at BMO Wealth Management in Dallas.
“At what point does the Fed think financial conditions have tightened enough? It’s nebulous… and you only really know if you’ve gone too far after the fact.”
The US economy contracted in the first and second quarters, fueling an ongoing debate over whether the country is or will be in a recession. Continue reading
Along with the contractions, last week’s two reports suggesting that inflation was likely to have peaked in July took some pressure off the Fed to deliver another outsized rate hike at its September 20-21 monetary policy meeting. The US annual CPI rose a weaker-than-expected 8.5% last month after rising 9.1% in June, while US producer prices also fell an unexpected 0.5% m/m in July. Continue reading
Rising inflation
Futures traders tied to the Federal Funds Rate, the central bank’s benchmark interest rate, are now pricing in a 63.5% chance of a 50 basis point hike at the September meeting. FEDWACH
“We truly believe the Fed will slow down sooner rather than later. The data is starting to adjust and we’re seeing a slower economy,” said Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research in New York.
Still, their baseline scenario is that the Fed conducts QT unchanged, but uses this as leverage that can be adjusted in conjunction with rate hikes.
“If rate hikes are fast, violent, and reverse, then they need to stop QT,” Jones said. “If rates are slowly rising and leveling off, they can continue QT for an extended period and tighten policy through the back door rather than the front door.”
After the tamer CPI reading, several Fed officials said it was too early to announce victory on the inflation front. Continue reading
“Inflation is way, way above anything that could be called price stability. There is a very long way back to acceptable levels of inflation,” said Jamie Dannhauser, economist at London-based wealth manager Ruffer LLP.
Dannhauser doesn’t think falling inflation numbers will affect the Fed’s QT plan.
He added that further better-than-expected news on inflation, to the extent that it changes the fundamental outlook for monetary policy, will be reflected in the downward shift in the Fed’s forecast for the central bank’s interest rate.
‘BEHIND THE CURVE’
The Fed’s balance sheet was nearly $9 trillion last week. Its holdings of Treasuries and mortgage-backed securities have not declined significantly since June, when the Fed began QT, but should decline over time, although it won’t do so in a straight line.
“The impact of QT is very small right now,” said Thomas Simons, an economist at Jefferies in New York.
Accelerate quantitative tightening
But bank reserves held at the Fed have fallen to $3.3 trillion, down about $1 trillion from a peak of $4.3 trillion in December 2021. Analysts said the decline in reserves was faster than many expected. In the Fed’s last QT, $1.3 trillion in liquidity was drained over five years. Continue reading
The Fed has not announced a target size for its balance sheet. Gennadiy Goldberg, senior rates strategist at TD Securities, believes the Fed’s ultimate goal is to reduce the balance sheet to a point where bank reserves reach about 9% of GDP, where they were prior to the September 2019 liquidity crisis. Continue reading
A slowdown in the QT would be an option if it creates a shortage of bank reserves that begins to constrain banking activities such as lending or market-making, analysts said.
Jay Hatfield, chief investment officer at Infrastructure Capital Management in New York, thinks the Fed should slow the pace of QT as the market doesn’t need another $1 trillion reduction in bank reserves.
“That would be catastrophic for bonds and stocks,” Hatfield said. “Unfortunately, the Fed ignores liquidity and money supply almost everywhere. As a result, the Fed is consistently behind the curve when it comes to controlling inflation and anticipating deflation.”
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Reporting by Gertrude Chavez-Dreyfuss; Additional reporting by Karen Brettell; Edited by Alden Bentley and Paul Simao
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