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posted on 15 June 2017

The Changing Eras: From Easing To Tightening

Written by , Difference Group

After half a decade of ultra-low rates in the United States, the Fed is hiking rates and moving ahead to reduce its massive $4.5 trillion balance sheet. The consequences will reverberate across the world, including Asia.


Before the Trump era, the Federal Reserve hoped to tighten monetary policy more often and aggressively than markets anticipated. But since November, US economic prospects have fluctuated dramatically, from the Trump trade to new volatility.

In its May meeting, the Fed left its target range for federal funds rate steady at 0.75-1 percent, in line with market expectations. Then this week they raised another 25 bps. It is likely to climb to 1.3 percent by the year-end and to exceed 3 percent by 2020.

In other major advanced economies, monetary stance has remained broadly unchanged. The European Central Bank (ECB), led by Mario Draghi, held its benchmark rate at 0 percent in April. While the ECB has signaled impending normalization, it will continue its asset purchases until the year-end. Even if the ECB begins rate hikes in 2018, they are likely to be low and slow. The rate could climb to 1 percent by 2020.

In Japan, Abenomics has failed, despite slight improvement in short-term growth prospects. As introduced by Haruhiko Kuroda, the chief of the Bank of Japan (BOJ), negative rates and huge asset purchases will continue. The rate may remain negative (-0.1%) until 2020 - by then Japan’s sovereign debt will exceed 260 percent of its GDP.

Yet, rate normalization is only a part of the story. After the Fed began its historical experiment with quantitative easing (QE), its then-chief Ben Bernanke accumulated a portfolio of some $4.5 trillion. Now the question is how his successor Janet Yellen plans to reduce it.

Adding to uncertainty is the fact that she is likely to be replaced at the end of her term in 2018 with a Republican whose views of US economy and markets are more in line with those of the Trump administration.

Subdued balance-sheet contraction

Since 2008, I have argued that, despite its hawkish rhetoric, the Fed will not be able to increase rates as early, as often and as much as it initially hoped. And nor will the Fed reduce its balance sheet as early, as often and as much as it initially signaled. Though widely different from the consensus half a decade ago, it seems now that both forecasts have been to the point.

The Fed’s current objective seems to be to hike rates up to only 3 percent.

Theoretically, the Fed has a half a dozen options to reduce its balance sheet, according to its minutes. In practice, it will opt for one of three scenarios. It can sell some assets at once or over time. It can halt the reinvestment of maturing assets. Or it will taper the reinvestment of maturing assets.

The latter is the most likely option since the Fed has officially announced its intention to deploy interest rate as its main instrument (which requires gradual shrinking of the balance sheet). The Fed’s objective is not to fully unwind its balance sheet. Rather, it may reduce its balance sheet by about $2 trillion in some 4-5 years, according to its minutes.

Concurrently, the role of the remaining $2.5 trillion could probably be legitimized as a “new policy instrument," which would be deployed as a cushion amid future crises. Prior to the global crisis and the QE rounds in major advanced economies, there was little understanding about the probable impact of balance sheet expansion on monetary conditions. Bernanke deemed such measures necessary, but critics saw them as neither effective nor harmless but as harbingers of an “inflation-holocaust."

Today, the understanding of the impact of balance sheet contraction on monetary conditions remains equally deficient. Consequently, critics are likely to portray Yellen's QT measures as ineffective, adverse, or harbingers of an impending “deflation-holocaust."

What seems certain is that, as the Fed plans to continue increasing rates, even as it is reducing its balance sheet, both activities will translate to tightening monetary conditions - not just in the US but around the world. Unfortunately, the track record of the Fed’s tightening is dark - even without balance-sheet reductions.

Reversal of 'hot money' flows?

In the early 1980s, Fed chief Paul Volcker resorted to harsh tightening that devastated US households, while leading to a "lost decade" in Latin America. Subsequently, Alan Greenspan’s rate hikes brought down struggling savings and loans associations, forcing Washington and states to bail out insolvent institutions.

In the early 1990s, Greenspan again seized tightening but then reversed his decision, which undermined expansion.

In the first case, global growth decelerated to less than 1 percent; in the second, it plunged to 4 percent below zero in developing nations.

In 2004-7, the rate hikes by Greenspan and his successor Ben Bernanke contributed to the global financial crisis. In low-income economies, growth stayed at 5-7 percent thanks to China's contribution to global growth. During the QE era, after traditional monetary policies had been exhausted, the central banks of advanced economies effectively created what I termed the "hot money" trap, thanks to short-term portfolio flows into high-yield emerging markets. As a result, the latter had to cope with asset bubbles, elevated inflation and exchange rate appreciation.

That’s when Brazil’s Minister of Finance Guido Mantega first warned about “currency wars," while China’s Minister of Commerce Chen Deming complained the mainland was being attacked by “imported inflation." Assuming a reverse symmetry, the impending US hikes have potential to attract "hot money" outflows from emerging economies leaving fragile countries struggling with asset shrinkages, deflation and depreciation.

In that scenario, the “hot money" trap of the early 2010s would be replaced by the “cold money" trap in the late 2010s.

On the one hand, today emerging economies are stronger and better prepared to cope with tightening. On the other hand, global growth is no longer fueled by major advanced economies as in the 1980s and 1990s, but by large emerging economies, which must cope with their adverse impact - which, in turn, has potential to penalize global growth prospects.

In 2013, when Bernanke announced the Fed would no longer purchase bonds, the statement caused a mass global panic.

Today, the central banks of major advanced economies are navigating into new, unknown and dangerous waters. If, in the past, over-ambitious or misguided tightening caused “lost decades," today the net effect could be far worse. The brief “taper tantrum" in 2013 was one thing. Multi-year rate hikes, coupled with balance-sheet reductions, in major economies that are highly indebted, suffer from aging demographics and are coping with secular stagnation - well, that’s a different story altogether.

This article was adapted from a commentary published by the South China Morning Post 04 June 2017.

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