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Quantitative tightening, redux

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Good morning. As if Spotify needed more problems, the streaming service ate dirt in after-hours trading yesterday on a bad subscriber growth outlook. Facebook and PayPal lost as much as a quarter of their share prices for similar reasons. Yet Google is doing just fine. Is there a pattern here?

We’ll have more to say on earnings tomorrow. Today we think more about what QT means for markets and one big way the economy is returning to normal. Email us: [email protected] and [email protected]

What happens when the Fed balance sheet shrinks? (part 2)

Here are some striking comments about how quantitative easing and tightening work, from someone who would know. Claudia Sahm of the Jain Family institute is an economist who worked at the Fed for a decade. She spoke on a UBS webcast this week about how the US central bank will tighten policy given low unemployment and high inflation:

The extra layer of problems here is that the Fed is very uncomfortable with the balance sheet. That’s one area where I look at the robust debate among the FOMC [Federal Open Market Committee] and I don’t feel so good. Because they don’t know why it works or how it works. They don’t have enough data points on this working well. They can’t talk about that much in public because they don’t want to unsettle markets or themselves . . . lift-off [of policy rates] is not the tricky thing here. It’s lift-off in a pandemic, it’s lift-off with a big balance sheet. How do you get out of [the QE] business?

The Fed does not know how its balance sheet operations affect the economy, and if they don’t know, you should consider the possibility that you don’t know, either. The last time we talked about this, a few weeks ago, we pointed out how the central bank delicately acknowledged its puzzlement in its last set of minutes, writing that “there is less uncertainty about the effects of changes in the federal funds rate on the economy than about the effects of changes in the . . . balance sheet.”

Sahm continues:

[Markets] are probably going to have to deal with a flatter [rate] path and more balance sheet runoff because, regardless of exactly how this works, this is a signal from the Fed — ‘we’re walking away from pushing so hard on the recovery.’ Because they do believe, and I think it’s pretty clear, that quantitative easing, after [policy rates] hit the zero lower bound in 2020, did help, whether it was through messaging or whether it was through pushing down interest rates . . . 

Whether [balance sheet runoff] is the same thing as a quarter point or 50 basis point [rate increase] we can argue about till the cows come home. But if the Fed wants out of that business . . . that would make a lot of sense.

To rehearse what we said last time, the standard theory of what happens when the Fed buys or sells treasury bonds is that, by changing the supply/demand balance for those bonds, they move yields up or down, which encourages/discourages lending and borrowing in the economy. Nice theory, but the facts are characteristically uncooperative. When the Fed started tightening last time, in 2018, rates were near their peak and fell as the central bank shrunk its balance sheet, the opposite of what the standard theory would predict.

There is a somewhat more satisfying story of what balance sheet reduction will do to risk assets. The Treasuries that the Fed is not buying have to be bought by someone else. And whoever that is will be buying them instead of something else — something such as stocks and corporate bonds.

John Hussman of Hussman Funds, who catches a lot of hell for being bearish for the last decade but brings rare rigour to market analysis, laid out the theory as follows in an email:

[During QE] the Fed purchases Treasury securities that would otherwise be held by the public, and pays for them with essentially zero-interest base money, which someone in the economy will have to hold until it is retired. As the Fed forces people in the economy to hold much more zero-interest liquidity than they want or need, they look for alternatives . . . [QE has] created trillions of dollars in zero-interest hot potatoes that drive . . . investors to chase yield in more speculative assets. Yet every time some buyer uses the cash to buy a security, the seller ends up holding the damned stuff.

What happens when the Fed runs off the balance sheet? . . . somebody is being relieved of zero-interest but low-risk base money in return for an interest-bearing but higher risk Treasury security. This doesn’t necessarily drive the level of interest rates higher. But let’s be clear — it does finally make someone happy with what they’re holding. And as the pile of zero-interest hot potatoes is reduced, so finally may the deranged level of yield-seeking speculation.

This “hot potato” theory of the Fed’s balance sheet has an interesting consequence.

Michael Howell of CrossBorder Capital summarises the theory like this: when there is less liquidity in the system, there is more risk, and more risk aversion. The main reason for this is that when there is a lot of cash around (Hussman’s “zero-interest base money”) it is easy to refinance maturing debts, something that is always a primary concern in a heavily indebted economy. When liquidity declines, it becomes harder for weak companies to refinance. Some default. Credit spreads widen. Investors worry and look for lower-risk assets — paradigmatically, those very same Treasuries the Fed is selling.

This increased demand drives Treasury prices up and yields down, the opposite of what the standard theory would suggest. As Howell puts it, “Yes, when [the Fed] is actively buying or selling, that pushes yield down or up, but when you look at the longer term, the liquidity effect is dominant.”

This seems paradoxical: Fed creates demand for Treasuries by selling them. But the crucial point is that when the Fed sells a Treasury, it literally destroys the money it takes in, reducing system liquidity.

Is the market pricing in the possibility that quantitative tightening might push yields down?

One goods (and services) read

At risk of repeating a cliché, the pandemic packed a decade’s worth of change into a few months. No, really, look:

Chart of goods to services ratio

Between February and May 2020, the ratio of goods to services bought by US consumers wiped out more than a decade of declines. This has been pointed out many times, and for good reason: the huge shift of demand to goods is very inflationary.

We are finally seeing some clear signs of normalisation. December data came out last week showing consumers moving back from goods to services — and suggesting a similar move in November was not a blip. In durable goods, a big pandemic anomaly (think Peloton), the reversion was especially sharp. The chart below shows what fraction of consumer goods bought were durable goods:

chart of durable to overall goods ratio

There is chatter that more normal demand for goods is a bellwether of lower inflation, a case our colleague Martin Sandbu has forcefully made. We don’t know. All we’d point out is that coupled with the now-fully normalised personal savings rate, two of the biggest economic dislocations of the pandemic are fading. That surely means something for markets. Readers are invited to send their prognoses our way. (Ethan Wu)

One good read

A hacker known as P4x was himself the victim of an attempted hack by the North Korean government. He did not like this. So he shut down the country’s internet.

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