In December 2015, six years after the Global Financial Crisis (GFC) overwhelmed the global economy and caused interest rates around the world to be slashed, the US Federal Reserve raised the target for their benchmark federal funds rate by 0.25% to 0.5%. However, it then took a year for the tightening cycle to kick off in earnest, with another 25-basis point hike in December 2016 which, in turn, was followed by a series of 25 point hikes each calendar quarter that followed. This took the Fed’s overnight rate to 2.5% in December 2018. Within seven months, the Fed was forced to partially reverse some of this tightening, reducing its rate to 1.75% over the second half of 2019 as financial markets wobbled badly despite the economy performing well.
With the Federal Reserve again on the verge of a tightening cycle, financial markets are replaying the post-GFC playbook, and assuming the Fed are only going to be able to raise its rate to around 1.75%, well short of any assessment of the economically neutral level of interest rates, as they will be stymied by the desire to shrink their balance sheet too.
Why then in the face of multi-decade highs in inflation are markets so sanguine about the interest rate outlook? The answer lies in the Fed’s balance sheet, and in particular the level of excess reserves placed there by commercial banks.
When a central bank undertakes quantitative easing (QE), it creates reserves for itself and with these, buys government bonds and other assets. These sit as an asset on their balance sheet. The money they created to buy those assets ends up in the banking system, and in turn finds its way back to the central bank as excess reserves. These, like any bank deposit, are a liability for the central bank. Thus, in accounting terms, both assets and liabilities at the central bank have grown. When it comes to quantitative tightening (QT), the process is reversed; the central bank either sells or allows a bond to mature, thus shrinking their assets. However, their liabilities also shrink as commercial bank excess reserves fall in tandem.
When the Fed set out on QT last time, they set their compass by making two estimates of their liabilities rather than their assets. Firstly, how many notes and coins are required, and secondly what level of reserves do commercial banks need. The former is pretty easy – take your current number and assume it grows in line with nominal GDP. The latter was vaguer, so the Fed took regular surveys from all major banks and asked them their estimates of reserves going forward. This then informed the Federal Open Market Committee (FOMC) of a rough target for the optimal size of their balance sheet and so they set about shrinking it accordingly.
However, as time progressed and excess reserves shrank, it soon became apparent that the banks needed far more reserves than indicated. Quite why is not clear – the distribution across the sector is very uneven, so perhaps the survey gave a misleading number, or perhaps, because reserves are essentially a zero duration high quality asset and bonds were dumping, banks decided they wanted more than indicated. Whatever the reason, the Fed’s compass was on the wrong setting and they overdid QT and withdrew far more liquidity than the banking sector needed. It is this, rather technical aspect of the Fed’s operations that we believe was behind the aborted tightening cycle in 2016/2018 rather than the federal funds rate being driven to a level that the economy could not withstand.
This time, however, is different! To avoid the same happening again when it embarks on QT in this cycle, the Fed have introduced new on-demand tools to control overnight interest rates both to the upside and downside and in theory at least, they should be able to run their balance sheet down by more without causing the liquidity shortages that characterised the last tightening cycle. They are also in the process of reviewing the Supplementary Leverage Ratio which is applied to banks and currently excludes excess reserves and US treasuries from the calculation, again freeing up liquidity.
If this view is correct, the market is underestimating how far high interest rates will rise, meaning bond yields have much further to rise (and bond prices to fall) than hitherto.