Ecoinometrics - A year of quantitative tightening
What has the Federal Reserve accomplished with QT?
Believe it or not but it has already been a year since the Federal Reserve announced they’d shift from a quantitative easing to a quantitative tightening playbook. How much have they done in a year and what is the real effect of this policy change on financial assets and the economy at large?
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A year of quantitative tightening
The good thing about the Federal Reserve of late is that you don’t get any surprise. They always tell you months in advance what they are planning to do. And they do so for two reasons.
First they don’t want to spook the financial markets. The last thing the Federal Reserve wants is a meltdown due to a sudden change in monetary policy. To avoid that they use the 4 steps tactic:
We say we are thinking about thinking about doing something.
We are now thinking about doing something.
We will do that thing X months from now.
We are finally doing what we said we’d do.
That’s enough to soften any blow coming from a major change in policy. That also gives time to the Federal Reserve to gauge the reaction to their future plans, adjust or simply walk back on the idea.
Another aspect of announcing what you are going to do in advance is that market participants are likely to start implementing the effect of the policy changes even before you start rolling them. This last point is not to be underestimated. It means that in many cases the Fed has do less in order to achieve their goal.
We often repeat that the Federal Reserve has two levers for action:
The balance sheet.
The Fed Funds rate.
But actually they kind of have a third one:
Talking about doing things on the other two levers.
Some people like Jeff Snider are of the opinion that the Federal Reserve real power only lies in their speech (see his series about the Eurodollar to understand why Jeff is of this opinion). Other people think the Federal Reserve is all powerful when it comes to the big economic cycles.
Personnally I don’t think this is clear cut so I’d encourage everyone to read about the Eurodollar business and the role banks play in this system. The opacity of the Eurodollar system makes it hard to get hard conclusions based on data. But if you are interested I might write my thoughts on it in more details one of these days.
Let’s get back to Quantitative Tightening.
Jerome Powell announced in the fall of 2021 that they would start raising the Fed Funds rate (from zero) at the beginning of 2022 and would follow shortly after with some deleveraging of their balance sheet. How much of that have they done?
On the front of the Fed Funds rate they have done a lot. Not a lot if you compare it to the inflation rate (which is the whole reason they switched to QT), but compared to previous episode of QT they have certainly moved fast. Much faster that we have anticipated.
They said what they’d do and did what they said. If you trust the dot plot there is still a majority of votes for continuing to raise rates throughout this year before reversing next year.
As a reminder the dot plot shows where each member of the FOMC (each member is one dot for a given year) sees the Fed Funds rate over the next few years and over the long run. It is an indication of where the consensus vote for the Fed Funds rate might be in the next few meetings. Of course things can change in between but the idea is that bar a massive economic event things won’t change too much and it can be used as a guide.
As per the last FOMC meeting in December the plan is for the Fed Funds rate to average just above 5% in 2023 before moving back down to 4% in 2022. Given that the timing of the next recession is likely to be end of this year or beginning of next year that kind of pattern makes sense (even though the particular levels could be anything).
In summary Jerome Powell has been pursuing an aggressive policy when it comes to rate. The idea is pretty clear: make it more expensive for economic actors to take on new debt thus slowing down the economy.
On the side of the balance sheet their action has been more timid. In case you forgot the Fed can decide to conjure money out of thin air to buy bonds. That monopoly money goes on to pad the coffers of various banks allowing, in theory, money to flow more easily downstream to financial assets and the real economy.
Now the sequence that matters doesn’t start in 2022. The date that matters when it comes to the balance sheet is September 2019… Yes that a good six months before the COVID crisis hit.
Already at the end of 2019 the bond market was jittery and the Fed decided to reverse their tightening program. Of course that’s small compared to the amount of money that flooded the system after the COVID crash of March 2020. But it is significant to note that not everything was working perfectly in the financial system even before the COVID crisis.
So from September 2019 to February 2022 the balance sheet of the Federal Reserve expanded by $5 trillion. That’s a lot of money to enter the system.
And how much have they managed to get rid off during the one year of tightening? A grand total of $460 billion. That’s 9% percent of the amount added in the QE sequence… Most of it comes from getting rid of bonds. Some shedding of Mortgage Backed Securities comes to top it.
Said differently they haven’t done much on that front. At the current rate of contraction for the balance sheet it will take them 10 years to get back to the level of September 2019… We’ll never get back to that.
Last time there was a huge expansion of the balance sheet was during the Great Recession. A total of $3.6 trillion were added to the balance sheet after 2008 and by the time COVID hit they had only managed to reduce it by 20% percent ($748 billion). There is no reason to think that this time will be different.
Now the whole purpose of running this quantitative tightening playbook is to get inflation under control. So far the inflation rate looks like that.
That is from the moment Jerome Powell started talking about QT to headline inflation reaching a top it took almost a year.
But even that is debatable given that while headline inflation is down, core inflation isn’t. So far it has only reached a plateau. Which is the telltale sign that energy prices (which the Fed has zero control over) are the one that are creating this inflation downtrend not the parts of the economy that the Fed as a more direct effect on.
So at the moment they don’t have much to show for their work. They have made plenty of collateral damages though. As an investor the one you care about first is risk assets, which have been decimated.
At the same time the bond market was not there to save you. Everyone with money in a 60/40 portfolio can attest to that.
On top of that, now that the financial conditions are getting tighter the job market is starting to be affected. Startups and tech companies have been the first one to get hit as can be seen with the recent layoffs. That’s normal given they are highly dependent on debt (which is becoming extremely expensive) for their operations.
As a matter of fact Q4 2022 has seen more layoffs in startups than when the COVID crisis hit. And while we are only a week in 2023 the first quarter already looks bad. So it is unlikely to stop there.
Which is why the Fed is continuing on this tightening trajectory. They understand that creating tough economic conditions that will lead to pressure on the job market is about the only way they can kill inflation for sure. Until they have achieved this state they’ll keep the pressure.
As we’ve discussed here, if we get a typical cycle you can expect a recesssion towards the end of the year. Only when we get there will the Federal Reserve be satisfied that they have done enough. Which is why I wouldn’t bet on a particularly fast turn towards QE at this point. But let’s see how that plays out.
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Don’t forget to checkout other resources on the Ecoinometrics website such as:
A dollar cost averaging performance calculator for the stock market.
Which assets really hold up against inflation over the long run.
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Cheers,
Nick
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I’d love to get your thoughts about the Eurodollar system!