Analysis: The Fed faces a balance sheet dilemma as the US economy slows

The US Federal Reserve Board taken in Washington on March 18, 2008. REUTERS/Jason Reed/File Photo

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NEW YORK (Reuters) – The Federal Reserve is ahead of plans to double the pace of shrinking its massive $8.9 trillion balance sheet next month as inflation slows. are facing difficulties.

The referenced move to accelerate quantitative tightening (QT) is aimed at further draining the financial system of pandemic-era stimulus and raising long-term asset borrowing rates to dampen inflation. But that is happening at a time when the US central bank is pushing interest rates higher and stubbornly trying to keep high inflation in check. Inflation has now more than tripled his 2% target for the Fed.

But the double tightening makes it difficult for the Fed to achieve a “soft landing” that avoids a recession while slowing the economy. Some investors believe the economy is already in recession, and speculation is growing if something has to be given. , that may be the pace QT rolls out.

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“The Fed could eventually put quantitative tightening on a slow trajectory or end sooner than expected,” said Yung-Yu Ma, chief investment strategist at BMO Wealth Management in Dallas.

“At what point does the Fed see financial conditions tightening enough?

The U.S. economy contracted in the first and second quarters, fueling the ongoing debate about whether the U.S. is in, or will soon be, in a more

In addition to the contraction, two reports from last week that suggested inflation likely peaked in July put pressure on the Fed to raise rates too much again at its Sept. 20-21 policy meeting. It took. The US annual consumer price index rose a weaker-than-expected 8.5% last month, followed by a 9.1% rise in June, and US producer prices also unexpectedly rose by 0.5 on a month-to-month basis in July. % more

Futures traders tracking the central bank’s policy rate, the Federal Funds Rate, are pricing in a 63.5% chance of a 50 basis point hike at the September meeting.fed watch

“I really think the Fed is going to slow down sooner or later,” said Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research in New York. rice field.

Still, her base scenario is for the Fed to run the QT as-is, but use it as a lever that it can coordinate with rate hikes.

“If rate hikes become too intense and reversible, QT should be stopped,” Jones said. “If interest rates rise moderately and then plateau, we can continue QT for a longer period and tighten policy through the back door rather than the front door.”

Some Fed officials said it was too early to declare victory on the inflation front after the CPI more

“Inflation is well above what is considered price stability,” said Jamie Dunhauser, economist at London-based asset manager Rafar LLP. It is.”

Dannhauser doesn’t believe lower inflation will affect the Fed’s QT plan.

He added that there is more unexpected good news on inflation that will be reflected in a downward shift in the Fed’s forecasts for the central bank’s policy rate, in that it changes the fundamental view of monetary policy.

‘behind the curve’

The Fed’s balance sheet was nearly $9 trillion last week. U.S. Treasuries and mortgage-backed securities holdings haven’t dropped significantly since his June when the Fed started his QT, but they shouldn’t fall in a linear fashion, but they should decline over time is.

“At the moment, the effect of QT is very small,” said Thomas Simmons, an economist at Jefferies in New York.

However, bank reserves held by the Federal Reserve have fallen by about $1 trillion from $4.3 trillion in December 2021 to $3.3 trillion. In the Fed’s previous QT, he had $1.3 trillion in liquidity drawn over five more

The Fed has not announced a target size for its balance sheet. Gennady Goldberg, senior rates strategist at TD Securities, believes the Fed’s ultimate goal is to shrink its balance sheet until bank reserves reach about 9% of GDP. This is the level before the liquidity crisis in September more

Analysts say a slowdown in the QT could be an option if it causes a shortage of bank reserves and starts to restrict banking activities such as lending and market making.

Jay Hatfield, chief investment officer at Infrastructure Capital Management in New York, believes the Fed should slow down the pace of QT because the market doesn’t need to cut bank reserves by another $1 trillion.

“It would be devastating for bonds and equities,” Hatfield said. “Unfortunately, the Fed almost universally ignores liquidity and the money supply. We are always lagging behind in forecasting deflation.”

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Reported by Gertrude Chavez-Dreyfuss. Additional reporting by Karen Brettell.Edited by Alden Bentley and Paul Simao

Our Standards: Thomson Reuters Trust Principles.

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