Quantitative Tightening (QT) is a plan by the Fed to sell off its bond holdings to undo their acquisition of bonds during Quantitative Easing (QE) of 2009-2014. These sales or portfolio run off will be done gradually over several years and was started 13 months ago. The disposition is to be done by selling off or allowing portfolio “run off” of 15% a year of assets starting in 2020 and ending in December, 2025. The pace is scheduled to be increased next year to 15% of assets; the first year was at a smaller pace. Ben Bernanke said QE lowered rates 0.85%, other people have said it lowered rates 0.5%. Assuming we use Bernanke’s figure of 0.85% and the QT program’s effect takes several years then perhaps rates will go up about a seventh of 0.85% each year or about 12 basis points (that’s 0.12%) a year.
The ten year Treasury real yield is 1.1% per Bloomberg. (Nominal is 3.06%). The long term average real yield was 2.08%. This is a key benchmark for determining if rates are too low. If the gap between 2.08% and 1.1% is 0.98% and 0.85% of that gap is explained by QE, then a token difference or gap of 0.13% between 0.85% and 0.98% is the degree that rates are “too low” for reasons other than QE, assuming QT was suddenly ended. Considering the gigantic risk that disinflationary aspects of the EU and Japan can spill over into the rest of the world, then this petty 0.13% difference seems very reasonable.
The fear that QT will make domestic rates rise reminds me of someone drinking out of a glass on the bow of a ship during a storm with huge waves rolling over the ship. Such a person might worry that could spill his drink, but the real worry is the gigantic waves of economic problems in EU and Japan breaking over the bow.
Assuming QT continues at a modest pace then perhaps rates rise each year by 12 basis points, plus there is the gap of 0.13%. This is extremely petty compared to the contingent risk of the economy outside of the US crashing.
If the CPI YoY core of 2.1% (the recent 90 day Core CPI was 1.6%) is slightly off because of an error in “Owner’s Equivalent Rent” housing cost measurement then CPI YoY may be 1.85% or even lower. This measurement error could more than offset the 0.13% gap.
The oil price decline will help cut inflation even if some of the oil price cut was merely political and will eventually mean revert upwards. The price cuts did some deflationary damage to oil extraction equipment makers, etc. that will temporarily suppress inflation. If the world goes into a slow growth period bordering on a recession that should dampen inflation and reduce the Fed’s ambition to complete QT.
Assuming the Fed never relents in their QT program then eventually, in a decade, real rates should be roughly 1% higher. But if we are overdue for a recession and then after the recession of 2019 another one occurs in seven years in 2026 those two recessions could severely disrupt the QT program, probably a minimum of two years for each recession or even longer, so that could be another 5 years, perhaps in 2033, (in time for yet another recession!) before QT is done.
The massive overhang of excessive debt and prolonged period of low growth in the EU and Japan is an unprecedented situation that outweigh the domestic risks of an (allegedly) overheating labor market. The Fed’s goal of getting rid of QE assets reminds me of the World War I debts Germany was obligated to pay in the 1920s that were amortized until the 1980s, in a 60 year repayment plan. After a few years the payments stopped in the crash of 1929, and then after WWII ended in 1945, more new debts were imposed on Germany, which later resulted in a settlement that reduced their debt in 1953. The point is that gigantic debts simply can’t be paid and won’t be. In this case the Fed doesn’t owe money as a result of QE; however, it has a moral and financial management duty to undo the potentially inflationary acts of the QE program by selling its bonds and returning to normal. But this duty may be no more possible to fulfill than Germany’s 60 year plan to have a debt payoff.
The existence of hidden unemployed workers, based on Labor Force Participation Rates, implies there are roughly another 2% of the population who could join the officially unemployed, who now number 3.7%, thus making unemployment’s true rate 5.7%. This implies it will take another 1.5 years to reach truly tight labor markets of 4.0% unemployment. A labor market isn’t tight until ruthless bidding wars for employees take place with huge signup bonuses, pay raises far above inflation, dramatic labor strikes that inconvenience consumers, etc. Today’s average pay raise, which is slightly above inflation, may be because the highly skilled workers got the lion’s share of the raises and thus for the bottom 80% they didn’t a raise in real terms. There are so many workers in “fake” jobs working on a contingent basis (waiters, taxi drivers, Realtors, salespeople, franchisees) instead of a traditional job, yet these people are counted as employed. However, using a bank loan officer’s standard, employment that is unreliable or hard to verify should be discounted. Also a prudent consumer planning his budget should also discount income that is unreliable or volatile, to avoid overspending. Thus inflation caused by an improved labor market is not a concern. The optionality of today’s work force (which benefits employers who hire contingent workers and hurts workers) means that a “job” today has less inflationary impact than one did in previous eras.
Without the threat of labor-caused inflation it will be less easy for the Fed to stick their QT plan during the slightest hint of an impending recession, and thus the feared interest rate increases from QT may end up like predictions that the Y2K software crises would destroy the economy or predictions that a meteorite will destroy the earth, etc.
The Fed is boxed in. If they raise rates then the already very high US dollar will go higher, making exports harder to do, and this will make EM countries more likely to default on their debts to American banks, since they have to pay the loans with ever-more scarce dollars.
Investors need independent financial advice about misunderstanding the risks of QT versus QE.