Opinion – Why? Economês in good Portuguese: The ‘quantitative squeeze’ has begun

In addition to recent and future hikes in basic interest rates, liquidity conditions in the US economy will also be affected by the shrinking of the Fed’s balance sheet starting this month. The “quantitative easing” (QE) that resumed strongly in March 2020, in response to the financial shock at the beginning of the pandemic, will now give way to a “quantitative tightening” (QT).

Between March 2020 and March this year, the Fed bought $80 billion (R$409.5 billion) of Treasury bonds monthly and $40 billion (R$204.7 billion) of mortgage-backed securities. Paper retention in the Fed’s portfolio more than doubled in this period, from US$3.9 trillion (R$19.9 trillion) at the beginning of the period to US$8.5 trillion (R$43.5 trillion) in May, corresponding respectively to 18% and 35% of GDP.

The counterpart of such acquisitions is in net reserves in the private sector. Given the current overheated labor market conditions and inflation well above the target, the reduction in the Fed’s balance sheet will correspond to a gradual reversal of that counterpart in liquidity, as a reinforcement of interest rate hikes.

For QT, it will suffice that funds from maturing securities are not reinvested. The Fed set a monthly cap of US$60 billion (R$307.1 billion) of Treasury bonds and US$35 billion (R$179.1 billion) of mortgage bonds for balance sheet shrinkage starting in September, starting this month until August with half those amounts.

Under that plan, the Fed’s balance sheet is expected to shrink by around $520 billion this year. It will still enter 2023 well above the 20% of nominal GDP where it was before the pandemic. But the rate of decrease of US$ 1.1 trillion (R$ 5.6 trillion) a year starting in September will have a corresponding decline in the liquidity – bank reserves and deposits – available in the economy.

How complementary will base rate increases and QT be with respect to longer interest rates that affect decisions underlying aggregate demand (private sector investment and consumption) and thus inflationary stabilization? QE and QT are seen to tend to have a direct impact on longer interest rates.

Ultimately, it all depends on how private agents use signals to project future central bank decisions on interest rates. In 2013, all it took was a reference by then-president, Bem Bernanke, that a reduction in the pace of QE then under way was being considered, for a taper tantrum to occur, with markets anticipating a sharp rise in basic interest rates, with immediate effects on active. In turn, between the beginning and the end of the first QT – light and brief – in 2017, the premiums on 10-year Treasury bonds fell.

This time, however, it is possible to assume that the Fed wants the instruments working in earnest in the same direction of containing demand. Doubts concern the pace and extent of the tightening, both with regard to base rates and the size of the Fed’s balance sheet at the end of QT. After all, everything will depend on how employment and inflation behave along the way, taking into account the inevitable lag between monetary policy decisions and their effects on the economy.

Furthermore, there is another component in the evolution of liquidity that maintains a relative autonomy –and potential rebellion– in relation to what the monetary authorities formulate, even if conditioned by them: bank credit. In addition to the liquidity created/destroyed by the Central Bank, commercial banks also create more or less money via the bank multiplier, depending on how idle or not they decide to leave their reserves. Banks create money when they lend or acquire an asset. Central banks act on reserves, but what is made of them depends on the banks’ decisions to lend more or less.

Banks in the United States have created a lot of money lately. Bank credit grew by US$ 1.5 trillion (R$ 7.6 trillion) in 2021 and, since the beginning of the pandemic, it has been expanding at a pace not seen since before the global financial crisis in 2008. mitigating or –which is more likely– enhancing the effect of QT. But how much it will do is an open variable.

There is also another variable in the equation: the values ​​of financial assets. The valuation at market prices of assets in bank portfolios makes those prices transferable to bank credit via capital restrictions and other decision rules of banks regarding the volume of their operations. At the same time, tight liquidity conditions and expected interest rate hikes underlie the fall in equity markets this year, particularly in the case of long-lived assets with high prices relative to current yields, because of expectations of extraordinary future earnings. Higher expected interest rates in the United States have increased discounts on such future earnings. The recent deterioration of conditions in the real estate market, where an important part of the credit goes, tends to reinforce a cooling of bank credit as a potential compensator of QT.

Financial asset values ​​also affect the target of monetary policy, through the so-called “wealth effect” on aggregate demand. In fact, it can even be said that in recent decades the economic cycle in the United States and other advanced economies has been strongly conditioned by what is happening in their financial sphere.

Rising interest rates, QT and falling stocks are consistently pointing in the direction of economic slowdown and, tentatively, declining inflation. And the end is still far away.