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US federal reserve monetary policy

December 2018

The Fed: pausing for thought?

The US Federal Reserve claimed its monetary policy tightening campaign would pass off without incident. Nothing could be further from the truth.

The US Federal Reserve may come to regret suggesting that rolling back crisis-era monetary stimulus would be like “watching paint dry”.

That’s because the US economy is unlikely to grow quickly enough to justify the degree of tightening it envisages. The Fed could stop hiking interest rates as soon as the first quarter of next year.

Since October 2017, when the central bank started running down its securities portfolio, its “twin” tightening has seen the cost of borrowing rise by 100 basis points (bps) and its balance sheet shrink by USD350 billion, which we estimate is equivalent to an additional 35 bps of rate hikes.

This has already started to weigh on industries that are traditionally most sensitive to interest rates, including the auto and housing sectors, which together make up a tenth of the US economy.

As the drag from tightening gathers strength, the next shoe to drop may be business investment, which is responsible for 15 per cent of economic output.

The bond market has already discounted the possibility that the Fed will raise rates by an additional 50 bps between now and end-2019 and reduce the size of its balance sheet by a further USD500 billion, which is equivalent to another 50 bps of rate hikes (see chart). 

twin tightening bites
US interest rates, %, adjusted for quantitative easing and quantitative tightening
US interest rates

QT (Quantitative Tightening) refers to the Fed's balance sheet reduction. Source: Thomson Reuters Datastream, data as of 05.12.2018

But that, in our view, amounts to an over-tightening that could leave the already cooling US economy in a more fragile state.

According to our calculations, a 100 bps of tightening in financial conditions typically leads to a 1 percentage point reduction in GDP growth in the following year.

Throw into the mix persistent trade tensions and the fading effects of tax cuts and government spending1,  and the risk of a soft patch in the economy no longer seems like a distant possibility. It could emerge as soon as the first quarter of 2019.

Rather than risk economic pain, we believe the Fed will adjust the course of its tightening campaign by slowing the pace of interest rates rises. Putting the brake on portfolio asset sales would be more problematic as it would risk the wrath of Congress. Yet that too could become an option if a deeper malaise were to set in – what St Louis Fed President James Bullard describes as possible “cracks” in the economy. 

In the event of a Fed rate pause, short-term interest rates would fall faster than longer-term rates, leading to what is known as bull steepening of the yield curve.

And, perhaps more importantly, the US dollar, which is most sensitive to moves in the short-end of the yield curve, would weaken, providing some relief to emerging market economies in particular, where a large number of corporations have accumulated sizeable dollar-denominated debts.

If and when the Fed eases up on the running down of its balance sheet, long-term rates should move downwards in what is known as bull flattening.

As the decade since the 2008 financial crisis has shown, following the intricacies of Fed policymaking is nothing like watching paint dry.