Analysis-Fed faces budget dilemma as the US economy slows

Accelerating quantitative tightening (QT), as it is called, is intended to further drain pandemic-era stimuli from the financial system and raise lending rates for long-risk assets to weaken inflation. But it comes as the U.S. central bank continues to raise interest rates to curb stubbornly high inflation, which is currently more than three times the Fed’s 2% target.

The double tightening, however, makes it harder for the Fed to achieve a “soft landing” in which the economy slows but soon falls into recession. With some investors believing the economy is already in a recession, speculation is growing that if anything fails, it could be the pace at which QT is unfolding. According to some bond investors, however, there is little chance that the Fed will change its short-term plan.

“There is some leeway for the Fed to end up taking a slow trajectory on quantitative tightening or even ending it sooner than expected. But it’s hard to know (how) the Fed balances things,” said Yung-Yu Ma. , chief investment strategist at BMO Wealth Management Dallas.

“At what point does the Fed think financial conditions have tightened up enough? It’s unclear … and you really don’t know until afterward whether you’ve gone too far.”

The US economy contracted in the first and second quarters, amplifying the ongoing debate about whether the country is, or will soon be, in a recession.

In addition to the contractions, two reports last week suggesting inflation would likely peak in July took some pressure off the Fed to offer another oversized rate hike during the 20-month policy meeting and on September 21. The annual consumer price index in the U.S. rose 8.5% last month, a weaker-than-expected figure, after rising 9.1% in June, while producer prices in the U.S. United States The United States also fell 0.5% month-on-month in July, which is unexpected.

Chart: US CPI

Futures traders tied to the federal funds rate, the central bank’s benchmark rate, now estimate a 63.5% probability of a 50bp hike at the September meeting. [FEDWATCH]

“We really think the Fed is slowing down sooner rather than later. The data is starting to adjust and we are seeing an economic slowdown,” said Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research in New York. . .

However, its baseline scenario is that the Fed manages QT as it is, but uses it as leverage that can be adjusted along with rate hikes.

“If the rate hikes are fast and furious and reverse, then they have to stop QT,” Jones said. “If rate hikes slow down and stabilize, they can continue QT for a longer period and tighten policy through the back door rather than the front door.”

Following the weaker CPI reading, several Fed officials said it was too early to declare victory on the inflation front.

“Inflation remains far, far above anything that can be considered price stability. Returning to acceptable levels of inflation is still a very long journey,” said Jamie Dannhauser, economist at Ruffer LLP, low asset investment manager. London.

Dannhauser doesn’t think the falling inflation numbers will affect the Fed’s QT plan.

He added that further unexpected good news on inflation, to the extent that the underlying view of monetary policy changes, will be reflected in the downward shift in the Fed’s forecast for the key central bank rate.


The Fed’s balance sheet stood at nearly $ 9 trillion last week. Its holdings in Treasury bills and mortgage-backed securities have not declined significantly since June, when the Fed started QT, but they are expected to decline over time, even if it won’t be in a straight line.

“The effects of QT are very weak at the moment,” said Thomas Simons, an economist at Jefferies New York.

Chart: The Fed balance sheet

But bank reserves held by the Fed fell to $ 3.3 trillion, down about $ 1 trillion from the high of $ 4.3 trillion reached in December 2021. Analysts said the tightening in reserves was faster than what many expected. In the Fed’s previous QT, $ 1.3 trillion in cash was withdrawn over five years.

The Fed has not announced a target size for its balance sheet. Gennadiy Goldberg, senior rate strategist at TD Securities, thinks the Fed’s ultimate goal would be to reduce the balance sheet until bank reserves reach around 9% of GDP, the level they were at before the crisis Liquidity crisis of September 2019.

Slowing QT would be an option if it creates a shortage of bank reserves that begins to constrain banks’ activities such as lending or market making, analysts say.

Jay Hatfield, chief investment officer at Infrastructure Capital Management New York, thinks the Fed should slow the pace of QT because the market doesn’t need another $ 1 trillion cut in bank reserves.

“It would be catastrophic for bonds and stocks,” Hatfield said. “Unfortunately, the Fed almost universally ignores liquidity and the money supply. This is why the Fed is perpetually late in controlling inflation and anticipating deflation.”

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