Unpacking The U.S. Federal Reserve's “Hawkish” Pivot
Qatar National Bank | Dec 12, 2021 01:22AM ET
The US Federal Reserve (Fed) continues to dominate macroeconomic discussions. After supporting the “Great Pandemic Reflation” (2020-21), a stimulus-induced recovery that brought the US economy back to life from the depths of a sharp downturn, the Fed seems to be on the edge of a significant policy change to a more “hawkish” stance.
With the ultra-easy policy following the pandemic shock, the Fed cut interest rates to close to zero and injected massive amounts of liquidity into the financial system.
The liquidity injection took place either through emergency measures or through a large-scale asset purchase program (quantitative easing or QE) of USD 120 Bn a month.
As a result, the Fed’s balance sheet ballooned to more than USD 8.6 trillion in total assets. This helped to stabilize markets, boost sentiment and support credit and demand.
Sources: Haver, US Federal Reserve, QNB analysis
However, the Fed is now starting to enact its monetary policy “normalization” process. The change was officially announced in September 2021, when Jerome Powell, the Fed’s Chairman, indicated the expected timeframe of the “tapering” process, i.e., the process of scaling down the QE program.
Back then, Powell announced a gradual reduction of long-term asset purchases. QE already started to be reduced from USD 120 Bn per month to USD 105 Bn last month. According to the Fed's September guidance, QE is set to be continually reduced by USD 15 Bn all the way to mid-2022, when net asset purchases by the Fed would reach zero.
More recently, in his Congressional testimony on Nov. 30, Powell doubled down on the normalization narrative, suggesting that elevated inflation (core personal consumer expenditure price index—PCE—spiked to 4.1% y/y in October) could justify ending asset purchases sooner than planned, which would imply a faster than USD 15 Bn per month QE reduction.
This communication, interpreted as a “hawkish” pivot by several analysts, led to significant risk-off moves in markets, with equity prices declining, short-term interest rates rising and volatility increasing.
Get The News You Want
Sources: Haver, US Federal Reserve, QNB analysis
In our view, three factors explain Powell’s recent hawkish pivot towards a faster normalization of monetary policy.
First, the Fed's leadership was recently empowered by a fresh new four-year term, which strengthens the legitimacy of any significant policy changes. In fact, US President Joseph Biden announced the re-nomination of Jerome Powell for Chair of the Fed in mid-November.
The re-nomination took place against a backdrop in which “progressives” were advocating the nomination of more “dovish” names that would support “easier” policies for longer, in order to fund higher social spending from the government.
The confirmation of Powell was understood by many as an additional backing from the administration to a more hawkish monetary policy agenda on the back of a strong economic recovery and above target inflation.
Sources: Haver, QNB analysis
Second, to the extent that the US real economy still needs support to achieve pre-pandemic levels of employment, there is little evidence that more liquidity would be the right instrument to promote real growth and new jobs.
Currently, money supply growth is not feeding credit growth. Excess reserves are abundant in US commercial banks as they are holding much more cash than they need for their commercial operations.
The cash-to-total asset ratio of lending institutions, which captures liquidity conditions in the banking sector, has surged to close to all time highs. Therefore, QE is currently not supporting the economy while it is still contributing to asset price inflation which, indirectly, also feeds into consumer price inflation.
Third, as the Fed playbook requires the end of QE before any policy rate increases, the Fed is creating the conditions for a rapid response to potential price pressures on the inflation front. In other words, the Fed wants to be done with the QE tapering process as soon as possible so that it can quickly raise rates in case inflation accelerates further from here, requiring stronger action from policymakers.
All in all, the hawkish pivot is real. In our view, the pace of Fed tapering or QE reduction will likely increase to USD 30 Bn per month from the current USD 15 Bn per month. This implies that the QE is set to end in Q1 2022.
In principle, this can pave the way for rate hikes already in H1 next year. However, we expect it to be much more difficult to implement rate hikes than QE tapering.
This leaves us to place a question mark on the expected pace of rate hikes in H1 2021, given that the macro environment remains uncertain, in light of renewed COVID-19 concerns with the Omicron variant.
Trading in financial instruments and/or cryptocurrencies involves high risks including the risk of losing some, or all, of your investment amount, and may not be suitable for all investors. Prices of cryptocurrencies are extremely volatile and may be affected by external factors such as financial, regulatory or political events. Trading on margin increases the financial risks.
Before deciding to trade in financial instrument or cryptocurrencies you should be fully informed of the risks and costs associated with trading the financial markets, carefully consider your investment objectives, level of experience, and risk appetite, and seek professional advice where needed.
Fusion Media would like to remind you that the data contained in this website is not necessarily real-time nor accurate. The data and prices on the website are not necessarily provided by any market or exchange, but may be provided by market makers, and so prices may not be accurate and may differ from the actual price at any given market, meaning prices are indicative and not appropriate for trading purposes. Fusion Media and any provider of the data contained in this website will not accept liability for any loss or damage as a result of your trading, or your reliance on the information contained within this website.
It is prohibited to use, store, reproduce, display, modify, transmit or distribute the data contained in this website without the explicit prior written permission of Fusion Media and/or the data provider. All intellectual property rights are reserved by the providers and/or the exchange providing the data contained in this website.
Fusion Media may be compensated by the advertisers that appear on the website, based on your interaction with the advertisements or advertisers.