FRB to accelerate monetary tightening
FRB to accelerate monetary tightening
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With inflation rising, the U.S. Federal Reserve is expected to accelerate its monetary tightening policy. Let's take a look at five charts and data to see what this implies for the future.
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With this, the U.S. policy rate is expected to reach 1% by the end of 2022 and come above 2% by the end of 2023, with some monetary policymakers advocating for a more rapid rate hike.
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The lower limit of the U.S. Fed's policy rate was 2.25% from December 2018 to June 2019, which means there is now a possibility of exceeding that level in the near future.
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Reference Figure 01: Changes in policy rates of major countries (Source: Compiled from data of central banks of various countries)
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Figure 01 shows that the policy interest rates of major countries, which had been generally declining until the beginning of 2020, turned to an upward trend in 2021.
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As far as I am aware, the countries that raised interest rates in 2021 were Russia, Hungary, Poland, Norway, New Zealand, South Korea, South Africa, Mexico, Colombia, Brazil, Chile, Peru, and Argentina, while only Turkey and China lowered rates.
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Another interesting point in this chart is that from the middle of 2007 to the end of 2008, the FRB began to sharply cut interest rates in response to the subprime shock, on the other hand the European Central Bank and others even raised interest rates in the second half of 2008.
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The reason for this was the rising inflation rate in Germany and some other countries, but this might have hit the countries like Spain and Ireland that were suffering from the housing recession in the aftermath of the US subprime shock, leading to the European sovereign debt crisis later on. This is discussed in my book below.
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Reference: What has made Japan’s economy stagnant for more than 30 years?/ How to protect the pension and medical care systems (Arata Yaguchi: Kindle Edition $)
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In addition, although the FRB had already decided at its previous monetary policy meetings to accelerate the tapering process to slow the pace of FRB’s asset expansion and to halt asset expansion at the end of March, i.e., to end quantitative easing, at the last meeting, the timing and speed of the start of asset downsizing were also discussed.
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Asset downsizing means absorbing funds from the market by selling U.S. Treasuries and mortgage-backed securities that have been purchased as part of quantitative easing. In other words, in the near future, the FRB will tighten monetary policy in terms of both interest rates and money supply.
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Reference Figure 02: Total Assets of the FRB (Source: FRB)
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The change in the total assets of the FRB in Figure 02 starts from the time of the subprime shock. This allows us to infer how significant the bursting of the housing bubble known as the subprime shock was in the history of U.S. monetary policy.
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Nevertheless, the assets of the FRB remained at around $800 billion after that, and it was only after the Lehman shock that they began to surge. In other words, the policy rate, which fell sharply from 5.25% to near 0%, was not enough to prevent the Lehman collapse, and it can be seen that the FRB hurriedly started unprecedented quantitative easing.
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With the Corona shock, the FRB's assets surged even further, to about $8.8 trillion, more than ten times the size they were before the Lehman shock.
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Around this time, the Bank of Japan's assets expanded as well, with the ECB, Swiss National Bank and others introducing negative interest rate policies for the first time in history. The Bank of Japan also introduced this.
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This shows that the monetary policies of major countries as we see them today were unprecedented and unimaginable to anyone until more than a decade ago.
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It has begun to head in the direction of "normalization."
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One of the things predicted by the normalization of U.S. monetary policy is the end of the so-called money glut market.
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This is because the current global stock market rally started with the US quantitative easing in early 2009.
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Reference Figure 03: Changes in the New York Dow and FRB Assets (Source: Compiled from FRB and SBI charts)
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What we can see in Figure 03 is that the Dow has risen nearly five times while the assets of the FRB have risen more than ten times. This is a convincing increase, given that stock prices are not the only thing that has gone up during this period.
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What the chart also shows is that stock prices continued to rise both during the period of interest rate hikes starting in December 2015 and during the period of asset downsizing starting in 2018. It was only in 2015, before the interest rate hike, that stock prices were heavy on the upside, but with the rate hike, they started to rise, with only a short-term downswing.
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This suggests that even with the coming "normalization" of U.S. monetary policy, stock prices may remain firm, at least for the time being.
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As a matter of fact, though, the main driver of stock rally during this period was share buybacks by U.S. companies. And looking at the corporate excess cash suggests that it will continue to be at least one of the main drivers.
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Moreover, taking into account that bonds are the ones that lose the most value when inflation and interest rates rise, it seems reasonable to expect a massive inflow of money from the bond market and stocks would continue to rise. However, loss-making companies and companies with large net debt may struggle.
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As for that inflation, the CPI continued to rise both during the period of interest rate hikes starting in December 2015 and the period of asset downsizing starting in 2018.
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Reference Figure 04: U.S. Consumer Price Index for All Urban Consumers (Source: written in FRED)
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Did anyone mistake Figure 04 for the assets of the FRB or stock prices that we have been looking at?
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The U.S. inflation rate rose during the period of interest rate cuts prior to quantitative easing, fell briefly after the Lehman shock, and entered an uptrend with the start of quantitative easing.
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In my aforementioned book above, I explain that in Japan, monetary easing has also seen upward pressure on consumer prices. However, it is known that the subsequent consumption tax hikes and the Lehman shock have caused prices to start falling.
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Japan's combination of monetary easing and tax hikes, which are analogous to giving full gas pedal and full brake of a car at the same time, have kept the country from moving forward from deflation, consuming gasoline unnecessarily and nearly destroying the car itself, including its tires.
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So why did U.S. consumer prices keep rising after 2016, even after monetary policy turned tighter?
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One reason is that that's why we must fear inflation. We don't need to look at history to see that inflation, once ignited, is difficult to quell. Even today, in Turkey and Argentina, inflation has not subsided even when interest rates have been tightened to considerably high levels.
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In the case of the U.S., even though it has turned to tightening, interest rates were still historically low, with a lower limit of 2.25%. In addition, the FEB's assets were about $4 trillion, four or five times as much as before the Lehman shock. This means that inflation might not be easily contained.
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The other factor is the fiscal aspect.
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Reference Figure 05: US Personal Income and Breakdown of U.S. Government Spending (Source: U.S. Government Data Lab and Wall Street Journal)
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It is highly likely that the U.S. government's fiscal spending is pushing up prices. The U.S. government continues to spend more than it earns, and its budget deficit is ballooning, although not as large as the Japanese government deficit versus GDP.
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What stands out in Figure 05 is the growth of income compensation in the economy, which was stopped by counter Corona measures in 2020 and 2021. In fact, the personal income of Americans grew significantly by more than compensating for the wages they lost during that period.
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This is one of the main reasons why President Biden is able to claim that the United States is the only country whose economy has grown more after Corona than before.
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Nevertheless, the wealthy have benefited the most from this generous spending, and the benefits to the middle class and below have been offsetting by inflation, which may explain why his approval rating has been declining despite his claims.