The Federal Reserve’s attempt to shrink its balance sheet through so-called quantitative tightening, or QT, is “a complete mistake,” according to Mizuho’s chief US economist
“There is a non-trivial probability that market liquidity will be negatively impacted well before the projected $2 trillion has been eliminated, preventing the Fed from meeting its target,” Steven Ricchiuto, chief U.S. economist at Mizuho, said on Monday. The Fed is letting its bond holdings, which include US Treasuries, shrink under quantitative tightening while raising the benchmark interest rate as its main tool to combat high inflation in the US
The Fed’s balance sheet expanded to about $9 trillion during the pandemic after the central bank embarked on a bond-buying program known as quantitative easing, which included buying US Treasuries, to help provide liquidity to the market during the COVID-19 crisis.
“Bank liabilities expand to meet reserve balances in the system, and the Fed’s own analysis suggests that these liabilities are not easily reduced when the Fed allows its balance sheet to run out,” Ricchiuto wrote. “Furthermore, historical experience of how the system works in a large reserve framework is exceptionally limited and equating QT to rate hikes appears to be the wrong approach.”
In late October, Treasury Secretary Janet Yellen warned at a securities industry conference that the economic environment was “dangerous and volatile,” even as she stressed that the U.S. economy was “healthy” and described the financial system as “resilient”. Yellen noted at the time that “we’re very focused on the Treasury market,” saying “it’s critically important that it’s a deep, liquid, well-functioning market and that it serves as a benchmark for all other assets.”
The Fed said in its financial stability report earlier this month that the $24 trillion Treasury market has recently experienced low levels of market liquidity. John Williams, president of the Federal Reserve Bank of New York, warned in mid-November that liquidity problems in the Treasury market have the potential to hamper the Fed’s ability to transmit monetary policy to the economy.
President Joe Biden’s administration was working across agencies to pursue policies that could bolster liquidity in the US government debt market, according to Yellen’s remarks last month. He also said he didn’t see a transfer problem at the time.
Ricchiuto di Mizuho said in his note on Monday that quantitative easing, which involves the Fed buying bonds such as Treasuries, “is unlikely to be resumed given the ongoing fight with inflation.” In contrast, “in 2018-2019, deflation and secular stagnation were the top concerns for policymakers,” he wrote.
The Fed began raising rates in March to combat high US inflation that has risen in the wake of the COVID-19 crisis. Inflation has soared amid COVID-related supply chain disruptions as well as unprecedented monetary and fiscal stimulus designed to help the economy weather the crisis triggered by the pandemic.
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After Russia’s invasion of Ukraine, “even the Fed was quick to shift gears,” Ricchiuto said, with the Federal Open Market Committee adopting “a tightening policy” that left the central bank’s terminal rate “a unanswered key question”.
“Because monetary policy works with a lag and underlying economic demand has remained relatively resilient, the terminal rate has become a moving target,” according to Mizuho’s note.
That’s why the Fed “has taken a data-driven approach to rate hikes,” with FOMC members looking for “the level that will correct the labor supply-demand imbalance,” Ricchiuto said. “Our reading of the data suggests that at 5%, the term structure of rates is still well below the likely final peak in short-term rates this cycle.”
Ricchiuto also raised concerns that investors may be too eager to look beyond the Fed’s monetary tightening after seeing signs of weakening inflation in October.
“The desire of market participants to look beyond tightening into eventual easing is simply increasing the likelihood that rates will need to go higher and stay there longer for the Fed to meet the necessary and sufficient conditions to reverse its approach restrictive,” he said. .
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The next Fed policy meeting is scheduled for December 13-14.
Meanwhile, the yield on the 10-year Treasury note TMUBMUSD10Y,
closed unchanged at 3.701% on Monday, according to Dow Jones Market Data. But so far in 2022, 10-year yields have remained up about 2.2 percentage points, rising this year as the Fed hikes rates.
US stocks hurt by rate hike in 2022, with the S&P 500 SPX,
down 16.8% through Monday. The S&P 500 closed down 1.5% on Monday, while the Dow Jones Industrial Average lost 1.4% and the Nasdaq Composite COMP,
it fell 1.6%, according to Dow Jones Market Data.
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