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 U.S. economist.
“There is a non-negligible likelihood that market liquidity will be adversely affected well before the $2 trillion target is reached, preventing the Fed from reaching its target,” said Steven Ricchiuto, an economist on Monday. American chef at Mizuho. The Fed is letting its bond holdings, which include US Treasuries, decline under quantitative tightening while raising its benchmark interest rate as its main tool to fight high inflation in the US
The Fed’s balance sheet had stretched to around $9 trillion during the pandemic after the central bank embarked on a bond-buying program known as quantitative easing, which included the purchase of US Treasuries, to help provide liquidity to the market when the COVID-19 crisis hit.
“Bank liabilities are growing to meet reserve balances in the system and the Fed’s own analysis suggests that these liabilities are not easily reduced when the Fed lets its balance sheet sink,” Ricchiuto wrote. “Furthermore, the historical experience of operating the system in an abundant reserve setting is exceptionally limited and equating QT with rate hikes seems like the wrong approach.”
In late October, Treasury Secretary Janet Yellen warned a securities industry conference that the economic backdrop was “dangerous and volatile”, even as she stressed that the US economy was “healthy” and described the financial system as “resilient”. Yellen remarked at the time that “we are very focused on the Treasury market”, saying “it is extremely important that it is a deep, liquid market that works well and acts as a benchmark. for all other assets”.
The Fed said in its Financial Stability Report earlier this month that the $24 trillion Treasury market had 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 could hamper the Fed’s ability to transmit monetary policy to the economy.
According to Yellen’s remarks last month, President Joe Biden’s administration was working across agencies to pursue policies that could shore up liquidity in the US government debt market. She also said she didn’t see a market problem at the time.
Mizuho’s Ricchiuto said in his note on Monday that quantitative easing, which involves the Fed buying bonds such as Treasuries, “is unlikely to reset given the ongoing fight against inflation.” By contrast, “in 2018-19, deflation and secular stagnation were top concerns for policymakers,” he wrote.
The Fed began raising rates in March to combat high US inflation that surged 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 measures designed to help the economy through the crisis triggered by the pandemic.
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After Russia invaded Ukraine, “the Fed also shifted gears quickly,” Ricchiuto said, with the Federal Open Market Committee adopting “a restrictive policy” that left the central bank’s terminal rate “a key unanswered question”.
“Because monetary policy is operating 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 imbalance between labor supply and demand,” said Richchiuto. “Our reading of the data suggests that at 5%, the term rate structure is still well below the likely final peak in short-term rates of this cycle.”
Ricchiuto also raised concerns that investors might be too eager to look past the Fed’s monetary tightening after seeing signs of weakening inflation in October.
“Market participants’ desire to look beyond tightening to eventual easing only increases the likelihood that rates will have to rise and stay there longer for the Fed to create the necessary and sufficient conditions to reverse its restrictive stance. “, did he declare. .
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The next Fed policy meeting is scheduled for December 13-14.
Meanwhile, the yield of the 10-year Treasury note TMUBMUSD10Y,
ended 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 as the Fed raised rates this year.
US stocks have been hit by rising rates 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,
fell 1.6%, according to Dow Jones Market Data.
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