Source: Wall Street News
Ku Chaoming pointed out that structural problems left over from the QE era are weakening the effects of the Federal Reserve's austerity policy — despite continuous sharp interest rate hikes, the financial environment is still relatively relaxed. In the face of high inflation and large amounts of liquidity in the service sector, the Federal Reserve will need a longer period of high interest rates to achieve the same effect as the previous policy.
The US manufacturing PMI data for May, which was released overnight, unexpectedly hit a two-year high. Inflation resilience exceeded market estimates, and the probability that the economy would “not land” increased. Combined with the minutes of the US Federal Reserve's May meeting released earlier, the minutes of the May meeting showed that policymakers agreed to maintain higher interest rates for a longer period of time, completely disrupting the market's hard-won interest rate cuts.
While expectations of interest rate cuts are repeated, Gu Chaoming, chief economist at the Nomura Capital Markets Research Institute, wrote an article this week pointing out that structural problems left over from the quantitative easing era are weakening the effects of the Federal Reserve's austerity policies, making it difficult for the Federal Reserve to fight inflation.
The report said that just a few weeks ago, the financial market was still looking forward to a “soft landing” for the US economy, and even praised Federal Reserve Chairman Powell as a “contemporary Greenspan.” The data at the time suggests that Powell successfully reduced the inflation rate to the target level without raising the unemployment rate or triggering a recession.
However, as a series of recent economic data were better than expected, the so-called “Golden Girl economy” became a dream, and expectations of “no landing” continued to heat up, and the market began to worry that the Federal Reserve would have to maintain high interest rates for a longer period of time.
Ku Chaoming pointed out that in the case of high inflation and large amounts of liquidity in the service sector, the Federal Reserve will need a longer period of high interest rates to achieve the same effect as the previous policy.
Austerity may not be strong enough
According to Ku Chaoming's analysis, the Federal Reserve seems to have realized that the current level of austerity may not be enough.
Powell admitted at a recent press conference that in addition to financial austerity, natural easing of supply chain issues is also a key factor in the decline in the inflation rate. This suggests that the Federal Reserve realizes that the cooling in inflation may not be entirely due to austerity policies.
Federal Reserve officials originally hinted that interest rates might be cut three times this year, but are now discussing the possibility of maintaining high interest rates. This reflects their growing concerns about inflation and realizes that austerity may not be strong enough.
The FOMC meeting minutes released on Wednesday show that due to poor inflation data for the first quarter, Federal Reserve officials expect to wait and see for a longer time to be more confident that inflation will fall to the target, suggesting that they are not in a hurry to cut interest rates and that interest rates will remain high for longer. A number of officials also expressed their intention to raise interest rates further once inflation reignites.
Furthermore, strong economic data suggests that high interest rates have not been as effective in curbing economic activity as expected, which makes the Federal Reserve feel that the effects of financial austerity may fall short of expectations.
Have traditional monetary policy tools failed? The decline in inflation may be due to supply chain easing
Ku Chaoming pointed out that one of the main problems currently plaguing the Federal Reserve is that once quantitative easing is implemented, it will become very difficult to tighten the financial environment thereafter.
In the past, the Federal Reserve was able to effectively regulate the economy by adjusting policy interest rates and the supply of bank reserves. However, the quantitative easing policy implemented after the 2008 financial crisis caused banks to hold large amounts of excess reserves, which led to the failure of traditional instruments — the financial environment is still relatively relaxed despite continuous sharp interest rate hikes.
In other words, the current policy interest rate target range of 5.25% to 5.5% has less restrictive impact on the financial environment than in the past.
The National Financial Condition Index (NFCI) compiled by the Chicago Federal Reserve confirms this. The index is currently in the loose range of -0.53, and there has been little increase since the Federal Reserve began raising interest rates two years ago.
Ku Chaoming believes that the decline in US commodity inflation may be due more to the mitigation of supply chain issues in the early stages of the epidemic than to the Federal Reserve's monetary policy.
If the Federal Reserve's austerity policies are effective, the financial condition index should rise sharply, ultimately reducing inflationary pressure in the process of curbing demand and raising the unemployment rate.
However, although the financial condition index is still loose, stock prices, consumption, and employment are still strong, while the inflation rate has declined. This shows that the reason for the decline in inflation is not the effectiveness of the Federal Reserve's monetary policy, but rather the natural mitigation of supply chain problems.
With the resolution of supply chain issues, inflation began to ease, but now that the supply chain has basically returned to normal, inflation has stopped falling.
Gu Chaoming pointed out that the main source of current inflation is the service sector, and this sector is slow to respond to monetary policy. Furthermore, in the case of large amounts of excess reserves, bank interest spreads are narrowing due to competition between banks. All of this means that the Federal Reserve will need a longer period of time to raise interest rates to achieve the same effect as previous austerity policies.
QE has planted lightning in financial markets
Ku Chaoming also believes that the real estate problem brought about by quantitative easing has limited the effects of the Federal Reserve's interest rate hike.
Buyers who obtained mortgages at low interest rates during the quantitative easing period were unable to afford higher costs under current high interest rates. As a result, housing transactions and the supply of new homes were reduced, and the housing market was in short supply, reducing the sensitivity of buyers to the central bank's monetary policy.
As reflected in CPI data, the month-on-month increase in housing costs remained at 0.4% for the third month in a row in April, and the year-on-year increase was strong at 5.5%.
Furthermore, some financial institutions may face huge losses due to holding housing mortgages issued during the quantitative easing period (or securitized products of these mortgages), as the Federal Reserve raised interest rates sharply, such as Silicon Valley Bank (SVB), which went out of business at the beginning of last year, or causing more serious problems in the financial system, which may limit the room for the Fed to raise interest rates further.
It is worth noting that the Federal Reserve decided to slow the pace of quantitative austerity at the May FOMC meeting. Ku Chaoming believes that this indicates that they may be concerned about potential liquidity problems in some financial institutions, but this is contrary to the goal of normalizing monetary policy as soon as possible, and the Federal Reserve faces a dilemma.
But if certain financial institutions in the US do have liquidity risks, then the decision to slow QT makes sense.
editor/tolk