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  
3
0%  
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.  
5
%
%
0
-
5%  
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  
2
.3 points above the July 2008 peak of 5.6%. It has also spread much more widely. Far from  
1
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).  
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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economic-research.bnpparibas.com  
2
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%  
5%  
0%  
2
tion to the supply shock (see chart 3 and Wolf, 2021 ).  
-
5%  
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)  
8
6
4
%
%
%
30%  
2
0%  
0%  
STRESS TEST  
1
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  
2%  
0%  
0%  
2
010  
2012  
2014  
2016  
2018  
2020  
2022  
3
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  
4
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  
4
3
2
2%  
5%  
8%  
5
tors . The risk of a rapid downturn cannot be excluded, and it was even  
mentioned in the discussions between central bankers, as illustrated  
6
by the minutes of the FOMC meeting .  
2
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.  
3
Household loans and loans to non-financial companies, including net debt securities  
th  
issues. Source: US Federal Reserve, Financial Accounts of the United States, 4 quarter  
2
4
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.  
5
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  
2
6
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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3
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  
7
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  
7
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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