Monday March 6, 2023

Executive Briefings Politics & Economy: The Fed’s Balance Sheet

The Peril of QT

At the time of writing this paper, the Federal Funds rate, one of the Federal Reserve’s key instruments for setting monetary policy, was between 4.5% and 4.75%. This basically works as a guide to set the cost of overnight lending amongst US banks. The rate has jumped from a fraction of a percentage point to its current range in less than a year. The debate now amongst analysts and bankers is how high will this go? The Fed rate is vital as it sets what constitutes the benchmark on borrowing costs, which in turn influence consumption, investment and thus economic growth.

The Fed has a delicate job to manage. On the one hand, should it seek to curb inflation, which is now sticky, it must resort to rate hikes. But this comes with consequences and the possibility of a recession, higher unemployment and falling house prices. In an environment where the bulk of household savings is in property (homes), this is no easy game to play. Politicians are quick to jump on the bandwagon with commentaries that make the Fed’s job harder. In any case, the generous post pandemic spending in America along with other countries, has ensured that monetary and fiscal policies are tugging in opposite directions. Still, some feel that interest rates have another 50 basis points to go before they peak. Whilst the jury is still out, Jerome Powell the Fed’s chief has made clear that his job remains unfinished until price pressures in the economy are sorted.

Where does this leave the rest of us? Frankly, in an uncertain and volatile situation. The equity and bond markets in India have assumed that US interest rates are near peak and have priced securities accordingly. Understandably, a few basis points rise in the Fed fund rate is unlikely to shock the markets, although a correction may well happen. But oddly markets seemed to have ignored the issue of quantitative tightening (QT). Perhaps, because it has never been done before; therefore it is plausible that its impact is being underrated.

Since mid 2022, the Fed has sold nearly USD 500 billion in assets and evidently has another USD 2 trillion to go. The bank bloated its balance sheet, post covid, to provide cheap money and liquidity; but enlarging the balance sheet in bad times can only work if it’s shrunk in good times. As quantitative easing (QE) drives down long-term interest rates and pumps liquidity, QT does just the opposite. So, in addition to the hikes in Fed fund rates, we must acknowledge that a shrinking balance sheet will have a cascading impact on costs of borrowing across the spectrum. As liquidity gets tighter, interests rates soar faster. So, what will at first seem a moderate impact, may abruptly turn ferocious as QE progresses.

Between August 2019 and February 2023, the Fed’s balance sheet soared from approximately USD 4 trillion to USD 8.5 trillion. Interestingly, in 2007, it was just 0.8 trillion. Whilst GDP too has grown over this time frame, the size of the balance sheet when measured against GDP has leapt from about 8% to 48%. Surely this must have long term implications, with inflation as an obvious outcome. So, it stands to reason that the Fed will press ahead with the shrinking, creating another unknown to worry about. In the best case, the impact on interest rates will be marginal, but equally the process could create market turmoil with funds flowing out of emerging markets generating interest and exchange rate pressures. Businesses should be prepared for some tremors over the coming 18 months.