Inflation’s unexpected rebound in May forced the Federal Reserve (Fed) to accelerate the normalisation of its monetary policy. In mid-June, the Federal Open Market Committee (FOMC) decided to raise the fed funds rate by 75 basis points (bp). At the same time, the Fed began to shrink its balance sheet through Quantitative Tightening (QT). For the moment, the US economy is holding up well, supported by robust fundamentals such as employment. Yet activity is beginning to slow under the impact of tighter lending conditions and deteriorating global economic prospects. The US economy will come under fierce pressure as it navigates towards a hard or soft landing.
Since 1 June, the US Federal Reserve (Fed) has been scaling back its balance sheet, limiting the reinvestment of maturing debt in its securities portfolio. Assuming that the pace of disposals stays at the announced level, the Fed could shrink its balance sheet by around USD1,600 billion over eighteen months. The Fed’s securities portfolio (assets on its balance sheet) will automatically reduce, whilst a share of its liabilities, the cash placed with the Fed by commercial banks and/or money market funds, will be destroyed. In 2019, the Fed’s first experiment in quantitative tightening (QT1) had to be halted: it had exhausted the “excess” reserves over and above the liquidity constraints applied to the banks1 and caused the money markets to seize up
Since the start of the year, media increasingly use the word recession and, over the same period, there was a significant increase in Treasury yields. The common driver behind these developments is, to a large degree probably, the more hawkish tone from the Federal Reserve. Unease about recession risk shows up in the latest quarterly Survey of Professional Forecasters conducted by the Federal Reserve Bank of Philadelphia. Recession probabilities across the projection horizon have moved higher and they are now well above what we have seen in the past at this stage of the tightening cycle. Exceptionally high inflation requires aggressive rate hikes to bring it back under control
US GDP growth was revised slightly downwards (-0.1 point) for Q1 2022, bringing the contraction in the annualised quarterly growth rate to -1.5%, contrary to expectations of a smaller contraction of only -1.3%. This correction can be attributed to a lower-than-expected private inventory investment (contribution of -1.1 points) as well as to the smaller contribution of investment (+1.2 point), especially residential investment. These revisions were partly offset by an increase in consumer spending of both goods and services (+2.1 points). Increases in exports and imports of goods cancelled each other out, leaving foreign trade’s net contribution unchanged (-3.2 points).
Over the past year, growth in the M2 measure of money supply in the USA1 has slowed from 27.1% y/y in February 2021 to 9.5% y/y in March 2022. This has mainly been due to the moderation in purchases, by the Federal Reserve (Fed) and banks, of Treasuries (blue bars) and mortgage-backed securities (MBS, hatched green bars). With the Fed having ended its net purchasing at the end of February 2022, the effect of QE was even smaller in Q1 2022. Since Q2 2021, the Fed’s repo arrangements with money market funds (light grey bars) have also resulted in the (temporary) destruction of money2. Other factors have pulled in the opposite direction
Contrary to expectations (annualised quarterly growth of 1%) US GDP contracted by an annualised quarterly rate of 1.4% in Q1 2022. This surprise fall hides a more nuanced and less negative reality. The economic engines of household consumption and business investment are robust and contributed 1.8 points and 1.3 points of growth respectively. However, reduced inventories at companies (contribution from changes in inventory of -0.8 of a point) and a reduction in public spending (contribution of -0.5 of a point), due to the ending of several support programmes, had a negative effect on growth. But the biggest negative contribution came from international trade (-3.2 points), which was the main reason for the drop in quarterly GDP
The US yield curve has flattened, giving rise to comments that, given the historical experience, risk of a recession is increasing. Yet, when drawing conclusions, caution is warranted. Market-based inflation expectations, which are very high, should decline after a number of rate hikes. This could pull down long-term nominal bond yields, leading to a further flattening or even an inversion of the curve. However, a decline in inflation is growth-supportive. Another reason for caution is that due to past central bank asset purchases, the slope of the yield curve is less steep. Past QE may thus reduce its quality as a leading indicator of economic growth. For these reasons, an alternative indicator has been developed
With inflation soaring, the US Federal Reserve announced that it would accelerate the process of normalising its monetary policy. Held near the lower zero bound until March, the key policy rate should rise to roughly 2% or even higher by the end of the year. The Fed will also reduce the size of its balance sheet. Operating at full employment, the US economy seems to have recovered sufficiently from the health crisis to pass muster. Yet it is still sensitive to credit conditions and is not immunised against the impact of the war in Ukraine.
Very few survey results are available yet for March 2022, but they are all mediocre, which shows that the harmful impact of Russia’s war in Ukraine is not limited solely to Europe. Although it hasn’t collapsed, the Conference Board’s household confidence index has fallen from peak levels. In the Philadelphia and New York regions, industrial leaders are seeing darker horizons, which is probably due as well to the resurgence of the Covid-19 pandemic in China, which promises to further aggravate supply chain tensions that are already very high.
Although the war in Ukraine is casting shadows on the global economy, the Federal Reserve announced that it would rapidly normalise US monetary policy. The Fed’s main arguments for taking action include surging inflation, which is also spreading widely, as well as tight labour market conditions and tensions over wages. As the self-sustaining nature of price increases is still open for debate, the projected tightening of monetary policy looks surprisingly strong. In an economic environment accustomed to cheap borrowing costs, the Fed’s move is not without risks regarding the future path of activity.
The FOMC has started a new tightening cycle and its members project 6 additional increases in the federal funds rate this year and 4 more in 2023. This hawkish stance is unsurprising. After all, the policy rate is very low, inflation is exceptionally high and the economy is strong. Given the Fed’s dual mandate, the pace and extent of rate hikes will depend on the evolution of inflation as well as the unemployment rate. Previous tightening cycles suggest that concerns about the risk of an increase in the unemployment rate have played an important role in the decision to stop hiking. The central bank will have to hope that inflation has dropped sufficiently by the time that this risk would re-emerge.
The latest monitoring report by the Basel Committee on Banking Supervision (BCBS)1 shows that despite very accommodating monetary policies, the immediately available liquidity position of the big American banks did not improve between Q4 2019 and Q2 2021, unlike that of the big European banks2. According to the first published data, the average short-term liquidity ratio, the Liquidity Coverage Ratio (LCR)3 was 116% for the American G-SIBs in Q4 2021, compared to 119% in Q4 2019, while that of the European G-SIBs was about 173% and 141%, respectively. In both cases, the average ratios were still significantly higher than the minimum prudential requirement of 100%
Unlike the European Union, which is relatively dependent on Russian energy, the United States does not have the highest exposure to the shock. As the world’s leading hydrocarbon producer, the US can even offset the shortfall of Russian production, at least partially. But in a more uncertain environment that is less propitious for spending, the US economy will not be sheltered. Looking beyond the stock market decline, a few business climate indicators, including the Philly Fed Index and the Empire Manufacturing Index, have already begun to signal a less euphoric environment.
In his press conference last week, Fed chairman Jerome Powell was very clear. Based on the FOMC’s two objectives – inflation and maximum employment – the data warrant to start hiking interest rates in March and, probably, to move swiftly thereafter. In doing so, it will be “led by the incoming data and the evolving outlook”. This data-dependency reflects a concern of tightening too much and makes monetary policy harder to predict. The faster the Fed tightens, the higher the likelihood of having it take a pause to see how the economy reacts.
The latest US economic data can be viewed in two ways. The optimistic approach would be to welcome strong Q4 2021 growth (6.7% annualised) and the fact that the economy is now almost no remaining Covid after-effects, since output has already moved back to its pre-pandemic trajectory. The second and more cautious approach would be to point out that investment has moved sideways and that growth would have been much weaker (1.6% annualised) without the exceptional contribution of inventories.
The minutes of the December meeting of the Federal Open Market Committee (FOMC) have shown a distinct and sudden shift towards a more hawkish stance. The reduction of the pace of net asset purchases (tapering) has been stepped up, the first rate hike is expected to come earlier and the FOMC participants favour an early start and a faster pace of quantitative tightening (QT). Although they are more relaxed about QT than in 2017, it remains a tricky operation. The challenge will be to find the right balance between QT and the number of rate hikes in order to bring inflation under control without jeopardizing growth. History shows that achieving a soft landing is difficult.
Since November 2020, there has been a significant increase in repurchase1 agreements by the US Federal Reserve (the Fed) with foreign central banks as part of the Foreign Repo Pool (FRRP). Two statistical series can be used to identify the Fed’s main counterparts.The structure of official foreign reserves2 indicates the amount of deposits (in the broad sense of the term, including repurchase agreements) made by each economy with “foreign central banks, the Bank of International Settlements, and the International Monetary Fund”. Given the weight of the USD, EUR, JPY and GBP in global foreign reserves, the Fed, the European Central Bank (ECB), the Bank of Japan (BoJ) and the Bank of England are probably the main beneficiaries
The Fed gets serious. Faced with an unprecedented increase in inflation (6.9% y/y in November, probably scarcely less in December) the Federal Reserve will tighten monetary policy more than previously expected.
With the inflationary surge in the US showing no signs of stopping, the Federal Reserve is no longer taking a accommodative stance and could accelerate the tapering of quantitative easing. Inflation has also spread to asset prices: real estate and stock prices have climbed to peak levels. Unless the emergence of the Omicron variant radically changes the situation, everything points to a key rate hike in 2022, possibly as early as next summer.
The rising trend in prices in the USA is far from over and has become a real focus of attention. In November 2021, inflation was 6.8% year-on-year (yy), its highest level since June 1982. Although soaring energy prices (up 33% yy) contributed to the increase in the cost of living, as in previous months, these were no longer the sole cause. Even stripping out energy and food, inflation was still 4.9% in November, another record. Having risen by 3.9% yy, rents, which represent the main item of expenditure for households (33% of the index), are beginning to have a significant effect. Far from being anecdotal, their increase has accelerated month after month in the wake of the surge in real estate prices
Last July, the US Federal Reserve (Fed) expanded its scope of intervention in the money markets. It now has a permanent repo facility (Standing Repo Facility or SRF) in addition to its reverse repo facility (Reverse Repo Program or RRP). These tools should allow the Fed to modulate its supply of central bank money, downwards as well as upwards, in periods of pressure on short-term market rates. In the current context of abundant central bank liquidity and limited supply of government securities, money market funds have made considerable use of the RRP. The ability of the SRF to reduce tension in the event of a drying up of central bank liquidity could, however, be countered by various factors such as the leverage constraints to which primary dealers and banks are subject.
The US banking system’s exposure to the Eurozone has significantly increased since 2016, the year of the referendum in favour of the UK’s exit from the European Union. Between 31 March 2016 and 30 June 2021, claims of the eight biggest US banks1 on Eurozone2 residents (excluding the public sector) have grown by more (USD 125.6 billion) than claims on the UK economy have fallen (USD 56.3 billion). The main beneficiaries of this switch include France (up USD 66.3 billion, or +47%), Luxembourg (up USD36.5 billion, +97%), Ireland (USD 28.8 billion, +46%) and Germany (USD 5.8 billion, +7%). Most of this expansion has been concentrated at Goldman Sachs and JP Morgan.US banks’ cross-border exposure to the Eurozone (i.e
The “transitory” surge in inflation is proving to be long lasting. In October, US inflation rose to 6.2% year-on-year, the highest level in 31 years. As in previous months, the main explanation is a ballooning energy bill (which accounts for 30% of this figure), but the acceleration in prices is spreading throughout the US economy. It can be seen in the cost of shelter, which is already up 3.5% year-on-year, and is surely bound to accelerate.
A recent academic paper argues that, considering the significant recent decline of consumer expectations, the US could be entering recession. However, Covid-19 complicates the interpretation of household confidence data. Fluctuations in infections play a role and the recovery from last year’s recession as well as other factors have caused a jump in inflation. Given the historically high quits rate, the weakening in household sentiment probably reflects mounting concern about the impact of inflation on spending power. Something similar has been observed in the latest consumer confidence data for France.
In response to the Covid-19 pandemic, the US Congress set up the Paycheck Protection Program (PPP) in April 2020 to provide loans backed by the Federal government to small and medium-sized enterprises (SME). When subscriptions closed on 31 May 2021, about USD 800 bn in PPP loans had been issued. Banks originated 80% of these loans and non-banking lending companies and fintechs issued the remaining 20%. Several aspects of this programme differ from France’s state-backed loan programme (PGE), especially its fiscal cost. First, in the United States, the Federal government fully covers the credit risk associated with government-guaranteed loans1. Second, American lenders receive fees to compensate for the cost of originating PPP loans (between 1% and 5% depending on the principal amount)
