At their next meeting on 25-26 September, the Federal Open Market Committee (FOMC) of the US Federal Reserve is widely anticipated to increase rates by 25 basis points
We agree with this consensus and anticipate another increase in December, which is the next time an FOMC decision is accompanied by economic forecasts and a press conference by chair Jay Powell.
Forecasting the number of rate rises in 2019 is more challenging as we approach a neutral policy stance. Should policy become tight and will r* (the equilibrium rate) increase?
These are crucial questions but not the focus of this short piece.
Instead, I turn to the part of the Fed's monetary policy that has been garnering less attention, namely quantitative tightening (QT). QT is the reduction of the Fed's balance sheet, which had ballooned to $4.5 trillion during quantitative easing (QE).
When the Fed started to unwind QE, it instigated a predetermined path of "caps". These are the maximum amount the Fed would let mature in any one month, with any excess maturity proceeds being reinvested.
The caps have been steadily increasing over time and in October, they go up to their current maximum of $30 billion in US Treasuries and $20 billion in mortgage backed securities (MBS).
By the end of August, the accumulated effects of the caps had been a $250 billion reduction from the peak balance sheet size.
I have been asked a few times how much the Fed will shrink its balance sheet. The answer is obviously only ever an estimate and depends on prevailing market conditions. Let's examine the asset side of the balance sheet:
One thing I can say with certainty is that the balance sheet is not contracting to pre-crisis $1 trillion levels, nor should we expect it to as the US economy has grown significantly in this time.
Over the last decade, real GDP growth has averaged only 1.5%, but nominally the US economy has still grown over $5 trillion to reach $19.5 trillion in 2017.
The Fed has been clear that ideally, it will offload all the MBS so there is no central bank interference in the credit allocation process.
I actually doubt it can achieve a complete MBS sell down during QT in this cycle however, because, in my opinion, the constraint to balance sheet shrinkage is more likely to be driven by the liability side of the equation.
There are various transmission mechanisms between QE and the real economy. The first is a signalling impact by the central bank that it will do whatever it takes although the law of diminishing marginal returns certainly applies here.
The cynic in me also would argue that the biggest single impact is by moving first and creating a competitive currency devaluation.
Most commentators focus on the asset side effects and examples include depressing term interest rates across the spectrum, boosting all asset prices and increasing financial sector trading profitability.
For every purchase, there is also an expansion of the Fed’s liabilities. Effectively, it has flooded the financial system with excess reserves – this can be seen clearly in the chart below:
In my opinion, the Fed will be able to continue QT until liquidity conditions in the financial system become tight. Bank reserves held at the Fed will not necessarily go to zero but there is no prima facie reason why they shouldn’t.
The best way of assessing whether liquidity is becoming challenging is to observe lending surveys and various market based signals. Unsurprisingly, there is nothing worrying at all emanating from the Senior Loan Officers surveys.
Of the market-based signals we examine, volatility (the VIX), LIBOR/OIS spreads and the shape of the US dollar yield curve (two-year yields compared to 10 year), only the latter is flashing an amber warning at present and the others are still bright green.
In conclusion, we expect the QT process to continue to occur relatively quietly in the background at $50 billion a month. There are many ramifications of a reducing supply of US dollars and we have already witnessed wobbles in some of the more vulnerable emerging markets: however, as John Connally, US Treasury Secretary in 1971, said: “The dollar is our currency, but your problem.”
My expectation is that the Fed’s balance sheet will not shrink beyond the level where bank reserves reach zero, which suggests an eventual size of $2.5 -$3.0 trillion: at current run rates, it will take two to three years to achieve this.
QT is undoubtedly tightening monetary conditions; when you hear the financial markets start screaming you will know that the Fed has done enough.