Interest rates are heading upwards and the economic damage from the continued and rapid increase in the cost of credit is only beginning to show. But higher rates won’t completely solve the inflation problem, at least according to some market observers. There are two “blind” spots. First, aggressive rate hikes by the Federal Reserve are only half the story of tightening.
How the central bank manages its balance sheet, which has nearly doubled to about $9 trillion and is equivalent to about 40% of US gross domestic product during the pandemic, is critical to fighting inflation. Second, structural problems in the labor market can undermine the effectiveness of a higher interest rate in a way not appreciated by central bankers and investors.
Fed officials have been relatively silent about quantitative tightening, the reversal of quantitative easing, through which the central bank bought about a third of the markets for US Treasuries and mortgage-backed securities. Quantitative tightening went into full swing this summer, with $95 billion of Treasuries and mortgage-backed securities withdrawn from the Federal Reserve’s balance sheet each month.
In October, the Fed’s portfolio decreased by $83 billion. Markets have overlooked the importance of quantitative tightening for two reasons, says Solomon Tadesse, head of North American quantitative equity strategies at Société Générale. His model says that if the Fed is to bring inflation back to its 2% target, then about $3.9 trillion of balance sheet shrinkage must accompany an interest rate of at least 4.5%. That amount of tightening, he says, is equivalent to an additional 4.5 percentage points of tightening.
Tadese’s calculations suggest that the US central bank’s tightening plans are both insufficient and grossly underreported. Chairman Jerome Powell has said the Fed will reduce its balance sheet by about $2.5 trillion; some Federal Reserve economists have estimated that this amount of tightening would be equivalent to about 0.75 percentage point of further tightening. But even a $2.5 trillion contraction would mean another three percentage points of tightening, Tadese says. The implications of quantitative tightening are greater than it appears.
The expert stresses the need to think about what the Fed is reversing – or not – reversing. He calls quantitative easing, launched during the 2008-2009 financial crisis when interest rates hit zero, a form of debt monetization. He calls it indirect monetization, as QE was assumed to be reversed, as opposed to a direct transfer from the central bank to the government and a permanent increase in the money supply, as happened in Zimbabwe and Venezuela.
The problem is that the longer the Fed’s balance sheet remains high, the more likely it is that quantitative easing will become irreversible. As Tadese says, quantitative tightening is essential because if you don’t do it effectively, you’re allowing for a higher level of acceptable inflation. The Fed is already engaged in quantitative tightening.
The point is that it is not enough, despite the relatively high pace given the size of its budget. Furthermore, there are already concerns about the functioning of the market as the Fed withdraws from the government bond market and continues to raise interest rates. Tadese doubts the Fed will get anywhere near the $3.9 trillion in balance sheet reduction he thinks is necessary. The upshot: It may have to raise its inflation target to around 4%. Meanwhile, a misconception about the labor shortage could undermine the impact of rising interest rates.
Consider a September survey by the Brookings Institution that found that labor market tensions explain three-quarters of the rise in the monthly consumer price index, excluding food and energy prices and outliers. Inflation has strengthened, largely due to a very tight job market and the rapid wage growth it has caused, said Gad Levanon, chief economist at the Burning Glass Institute. A rise in interest rates will inevitably raise the unemployment rate, and higher unemployment is supposed to correct for high inflation. But interest rates affect demand, not supply, and labor shortages are a tricky factor that raises the question of whether the normal transmission mechanism is broken.
The gap between the wage growth of those who change jobs and those who stay is the largest in history. That way, the “churn” rate will remain high, Levanon says, keeping pressure on employers to raise pay and pass higher costs on to customers, while worker turnover weighs on productivity.
Levanon pointed to a Conference Board report that showed employers’ total budget for pay raises grew 4.1% year-over-year in 2022, compared with a projected increase of 3.6%. For 2023, the increase is expected to accelerate to 4.3%, 40% higher than the typical annual increase during most of the decade before the pandemic. As Levanon argues, baby boomers are aging out of the labor force just as working-age population growth is slowing for the first time in US history.
At the same time, prime-age men remain out of the workforce in alarming numbers, and there has been a significant increase in the proportion of people not in the workforce due to disability. Budget under-contraction and structural weakness in the labor market mean that inflation may not cool as much as expected, despite the economic downturn caused by sharply rising interest rates.
Vincent Deluir, director of global macro strategy at StoneX Financial, says the Fed will have many scapegoats to justify the adoption of negative or inflation-adjusted real interest rates, including excessive fiscal stimulus, the war in Ukraine and the need to stabilize the financial system because quantitative easing and the 5% interest rate push will eventually break something.
Fed officials are correct that rate hikes will hurt demand. But they may be underestimating the bigger picture. Without much more aggressive quantitative tightening and with the central bank unable to remedy the labor shortage, weak economic growth will not be the only price for curing inflation. It will be accompanied by constant inflation.
