EcoFlash

About the tightening of the US monetary policy

ECO FLASH

N°22-05

25 mars 2022

UNITED STATES: ABOUT THE TIGHTENING OF US MONETARY POLICY

Jean-Luc Proutat

UNITED-STATES, CONSUMER PRICES BY MAIN ITEMS (YEAR-ON-YEAR)

Although the war in Ukraine is casting

shadows on the global economy, the

Federal Reserve announced that it would

rapidly normalise US monetary policy.

Feb.22

Jul. 08

25%

20%

15%

10%

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 econo-

mic environment accustomed to cheap

borrowing costs, the Fed’s move is not

without risks regarding the future path

of activity.

EX. VEHICLES ** EX. ENERGY, FOOD, APPAREL

CHART 1

SOURCE: BLS, BNP PARIBAS CALCULATIONS

Raising key rates in response to a pure energy or food prices shock is a monetary policy mistake

that was already committed in 2008. At the time, the Bank of England and the European Central

Bank (ECB) raised the cost of borrowing in response to surging oil prices (Brent crude oil rose as

high as USD 140 a barrel in summer 2008), just as the subprime crisis was gathering strength

and undermining economic prospects. What happened next is well known: after the bankruptcy

of Lehman Brothers in September, key rates had to be slashed, right after they were raised. On

16 March 2022, the Federal Reserve announced a new round of monetary tightening in the midst

of an energy crisis, even as Russia is waging war on Ukraine. Is the Fed about to make the same

policy mistake?

A PERIOD OF EXCEPTIONALLY ACCOMMODATING MONETARY POLICY COMES

TO AN END

The initial situations of these two periods seem to be very different. First, inﬂation was not the

same. At 7.9% year-on-year in February 2022, inﬂation is the highest in forty years and stands

.3 points above the July 2008 peak of 5.6%. It has also spread much more widely. Far from

being fuelled solely by surging energy and food prices , price increases have spread to numerous

items, including rents or even more durable goods, foremost of which are cars (see chart 1).

“Food” and “energy” contributed 36% of the February 2022 inﬂation ﬁgure (7.9% year-on-year). During the previous

peak of July 2008 (5.6% y/y), they contributed 66%.

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Exacerbated by the global Covid-19 pandemic, price increases have

cut short a historical downward trend resulting from two decades of

supply chain globalisation.

UNITED STATES, REAL INTEREST RATES

Lastly, and most importantly, the Fed’s decision comes at the end of

an exceptionally accommodating phase of monetary policy, unprece-

dented in modern US history. Maintained near the lower zero bound

since March 2020, real interest rates have plunged into negative ter-

ritory, sinking to depths never seen before (see chart 2). This was also

the case for bond yields, which remained very low thanks to the central

bank’s securities purchases. The last wave of quantitative easing (QE),

which amounted to USD 4,600 billion (20 points of annual GDP), fuelled

exceptional money supply growth and helped rekindle inﬂation, addi-

10y (Treasuries)

3 month

10%

tion to the supply shock (see chart 3 and Wolf, 2021 ).

The Fed met its initial goal of avoiding liquidity shortages and

countering the depressive effects of the Covid-19 pandemic, and the

economy recovered beyond all expectations. It has largely surpassed

pre-pandemic levels. With the jobless rate dropping below 4%, the

US economy is verging on full employment. The keyword thus became

the normalisation of monetary policy.

-10%

1962

1972

1982

1992

2002

2012

2022

CHART 2

SOURCE: IMF, REFINITIV, BLS

Just how far can the Fed go? According to the latest projections of

the Federal Open Market Committee (FOMC), the Fed funds target rate

could rise as high as 2.8% over a 15-month horizon, which implies six

more rate increases of 25bp each in 2022, and at least three more

in 2023. Starting in May, it will scale back the amount of securities

outstanding held as part of QE (USD 8,500 bn), at a pace that has to

be speciﬁed. As presented, the Fed’s current road map is much more

demanding than the December 2021 version. In the eyes of Fed Chair

Jerome Powell, this road map is workable because the US economy is

back to full health.

UNITED STATES, MONEY AND INFLATION

CPI 'core', y/y (LHS) M2, y/y (RHS, lagged)

30%

STRESS TEST

The planned monetary tightening appears to be a serious stress test.

Since inﬂation is supposed to decelerate, it implies at least a 5-point

increase in real key rates in a little more than a year. This is no small

matter for an economy which rely increasingly on credit. In 2021, net

private sector borrowing amounted USD 1,596 bn, the highest level

010

2012

2014

2016

2018

2020

2022

since 2007 . Temporarily hampered by the Covid-19 pandemic, leve-

CHART 3

SOURCE: BLS, FED

raged loans rebounded strongly, as illustrated by the increase in M&A

and securitisation activities (IMF, 2021) . Even as Federal transfers

were boosting the cash holdings of companies, their net debt swelled.

It has held at high levels as a share of GDP (chart 4).

UNITED STATES, NON FINANCIAL CORPORATE NET DEBT/GDP

For certain market participants, such as investment funds taking part

in leveraged buyouts (LBO) or Real Estate Investment Trusts, the Fed’s

action has already had concrete consequences by helping to ﬂatten

the yield curve. Transformation conditions tightened while acquisitions

demanded high earnings multiples, calming the enthusiasm of inves-

Recessions

Non. Fi. Corporate Net Debt / GDP

tors . The risk of a rapid downturn cannot be excluded, and it was even

mentioned in the discussions between central bankers, as illustrated

by the minutes of the FOMC meeting .

Since February 2020, the main M2 money supply aggregate has increased by 24

points of GDP, as much as between 2000 and 2019. See Wolf M. (2022) “As inﬂation

rises, the monetarist dog is having its day”, Financial Times, February 22.

Household loans and loans to non-ﬁnancial companies, including net debt securities

issues. Source: US Federal Reserve, Financial Accounts of the United States, 4 quarter

021.

The year 2021 was a record year for issues of Collateralized Debt Obligations (CLO):

USD 150 bn in the United States according to IMF estimates. See International Moneta-

ry Fund (2021), Global Financial Stability Report, Ch. 1, October.

Ibid, p.20-21. In 2021, nearly 60% of LBOs represented more than six years of EBITDA

(

earnings before interest, taxes, depreciation, and amortization), the highest level since

1987

1992

1997

2002

2007

2012

2017

2022

007.

."A few [..] participants raised concerns that a relatively ﬂat yield curve could

CHART 4

adversely affect interest margins for some ﬁnancial intermediaries, which may raise

SOURCE: BEA, NBER. BNP PARIBAS

ﬁnancial stability risks." Source: FOMC Minutes, 15-16 Dec. 2021, pp.4-5.

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By striking hard, the Fed is highlighting wage dynamics that are “in-

compatible with the objective of price stability”. Admittedly, at 6.7%

year-on-year in February 2022, average hourly wage growth is the hi-

ghest on record since 1982. Yet the health crisis makes it harder to

interpret this trend as it impact the composition of employment as well

as the distribution of wages. Looking at the employment cost index,

which has ﬁxed weightings and is not subject to the same bias, the

slope is less abrupt (+4.4% year-on-year in Q4 2021, in the broad sense

of the term, including social welfare beneﬁts). Even so, it is still higher

than pre-pandemic trend.

PRICE PER UNIT OF REAL GROSS VALUE ADDED AT 2021 Q3

NON FINANCIAL CORPORATE BUSINESS)

(

USD

1.17

Q/Q-4

5.1%

CONTRIB.

TOTAL

UNIT LABOR COSTS

0.70

0.29

0.4%

0.3%

3.5%

UNIT NONLABOR COSTS

15.8%

ow TAXES ON PRODUCTION AND IMPORTS *

0.08

163.3%

4.4%

As the Phillips curve would suggest, biggest pay increases occur in sec-

tors where post-crisis hiring needs are high, such as in hotel & restau-

rant services, transport & warehousing, or retailing. They are also hi-

gher than average in professional and business services, which account

for nearly a quarter of total employment in private services, and lie at

the heart of the digital transformation. Looking at all sectors, higher

wages are partly responding to stronger productivity gains, which are

UNIT PROFITS

0.18

9.6%

1.4%

(

*) NETS FROM TRANSFERS AND SUBSIDIES

SOURCE: BEA

TABLE 1

also breaking their pre-pandemic trend .

All in all, the increase in unit labour costs (wages and beneﬁts as a

percentage of real output) is still contained and has nothing to com-

pare with the double-digit ﬁgures of the early 1980s. In the breakdown

provided by the Bureau of Economic Analysis (BEA), it is not presented

as a key factor in the upturn in the price of value added in 2021. The

latter is due more to production and import taxes (driven up by higher

input costs) as well as to higher margins (table 1).

It does not seem very evident that a veritable price-wage loop is ta-

king shape in the United States. Although inﬂation has exceeded all

expectations and risks rising further, it does not seem very likely to

become permanent or self-sustaining. Yet to make sure it doesn’t, the

Fed has to get tough, even at the risk of triggering a hard landing for

the economy.

Jean-Luc Proutat

jean-luc.proutat@bnpparibas.com

In 2020 and 2021, the average annual growth rate of hourly labour productivity in the private sector was 2.3%, whereas the pre-pandemic trend was close to 1%. Source: Bu-

reau of Labor Statistics, BNP Paribas calculations.

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