Analysis: Fed faces balance sheet dilemma as US economy slows

The U.S. Federal Reserve building is pictured in Washington, March 18, 2008. REUTERS/Jason Reed

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NEW YORK, Aug 15 (Reuters) – With the recent slowdown in inflation, the Federal Reserve faces a conundrum ahead of a plan next month to double the pace at which it is shrinking its massive $8.9 trillion balance sheet .

The move to ramp up quantitative tightening (QT), as it’s been called, aims to further drain the financial system of the pandemic-era stimulus and raise borrowing rates for long-term assets in order to lower inflation. But it comes as the US central bank continues to hike interest rates to rein in stubbornly high inflation, which currently sits at 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 avoids a recession. With some investors believing the economy is already in a recession, speculation has grown that if anything should give, it could be the pace at which QT is unfolding. The odds, however, remain long that the Fed will change its near-term plan, according to some bond investors.

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“There is some leeway for the Fed to eventually be on a slow path of quantitative tightening or even end earlier than expected. But it’s hard to know (how) the Fed balances things out,” Yung-Yu said. Ma, chief investment strategist at BMO Wealth Management in Dallas.

“When does the Fed consider financial conditions to have tightened enough? It’s nebulous…and you really only know after the fact if you’ve gone too far.”

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

Alongside the contractions, two reports last week suggesting inflation likely peaked in July eased pressure on the Fed to deliver another oversized rate hike at its Sept. 20-21 policy meeting. The annual consumer price index in the United States rose 8.5% weaker than expected last month, after rising 9.1% in June, while producer prices in the United States also unexpectedly fell 0.5% on a monthly basis in July. Read more

Rise in inflation

Traders of futures tied to the federal funds rate, the central bank’s benchmark rate, are now pricing in a 63.5% chance of a 50 basis point hike at the September meeting. FEDWATCH

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

Yet his base case is that the Fed is running QT as is, but using it as leverage that can be adjusted in conjunction with rate hikes.

“If the rate hikes are going fast and furious and they reverse, then they need to shut down QT,” Jones said. “If rate hikes slow and level off, they can continue QT for a longer period and tighten policy through the back door instead of the front door.”

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

“Inflation remains well, well above anything that could be considered price stability. There is still a very long way to go back to acceptable levels of inflation,” said Jamie Dannhauser, economist at the manager of London-based assets Ruffer LLP.

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

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

‘LAST THE CURVE’

The Fed’s balance sheet stood at nearly $9 trillion last week. Its holdings of Treasuries and mortgage-backed securities haven’t declined significantly since June, when the Fed launched QT, but are expected to decline over time, although that won’t happen in a straight line. .

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

Acceleration of quantitative tightening

But bank reserves held at the Fed fell to $3.3 trillion, down about $1 trillion from a peak of $4.3 trillion in December 2021. Analysts said the contraction in reserves was quicker than many expected. In the previous Fed QT, $1.3 trillion in cash was withdrawn over five years. Read more

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 shrink the balance sheet to a point where bank reserves are around 9% of GDP, their level before September’s liquidity crisis. 2019. Read more

Slowing QT would be an option if it creates a shortage of bank reserves that begins to limit 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 ease 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 money supply. That’s why the Fed is perpetually lagging the curve of controlling inflation and expecting deflation.”

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Reporting by Gertrude Chavez-Dreyfuss; Additional reporting by Karen Brettell; Editing by Alden Bentley and Paul Simao

Our standards: The Thomson Reuters Trust Principles.

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