Is Quantitative Tightening a Major Policy Mistake for the Federal Reserve?

May 14, 2022 | Macroeconomics

Interest rates have been historically low for some time before the recent moves of the Federal Reserve. The dialogue over how transitory inflation is has changed and now the expectation is of further rate rises in the US. However, with inflationary pressures growing, how many rate rises can the US be expected to make in a challenging economic environment for them?

US economy at an inflection point

Despite the recent improvements, debt levels in the US remain precariously high. The bounce back from coronavirus meant that year-on-year growth of GDP in the fourth quarter of 2021 was 11.7% [1] – a welcome recovery. Nonetheless, as a developed economy, the US cannot expect to grow sustainably at this rate for long enough to significantly lessen the debt burden. We have previously written [2] about seeking inflation as a potential exit strategy and as CPI reached over 7% [3] year-on-year at the end of 2021, this seemed to be the case. However, recent announcements suggest that the US will not follow this course of action and instead actively seek to combat inflation with hawkish economic policy during 2022.

Restricting money supply and rate rises on the horizon

In fact, the Federal Reserve indicated in January that they will soon begin to taper their spending and implement Quantitative Tightening (QT). This is the opposite of Quantitative Easing (QE) – where central banks (such as the Federal Reserve) purchase bonds to increase the money supply in an economy. In practice this involves the creation of reserves out of thin air by central banks that are exchanged for bonds and sit as a liability on balance sheets in the banking system. For QT, bonds are “unprinted” or withdrawn from the economy and the private sector is expected to take up the slack of the reduced market liquidity. In practice, central banks allow the purchased bonds to mature, thereby removing the associated liabilities from the balance sheets of the banking system, contracting the supply of money in the economy.

Additionally, several interest rate rises are also expected during 2022, with one major investment bank suggesting that the US Federal Funds Rate will peak between 2.75% and 3%. We believe that such a policy is not in the best interests of the economic recovery of the US. Clearly, this will only worsen the debt problem, as it would imply an annual interest of nearly 40% of current tax receipts. In all probability, the situation would actually be even worse as a rise in interest rates would likely reduce tax receipts. Such a high interest rate burden is not sustainable in the long run and historically is considered a rule of thumb for triggering sovereign debt crises.

Equity markets key to the debt crisis

The situation is all the more precarious when you consider the recent movements of equity markets. Figures 3 and 4 [4] below shows the close relationship between the Wilshire 5000 index (a broad representation of US equities) and tax receipts in the US over time. There is clear evidence of a wealth effect – where the performance of equities, held predominantly by the wealthiest (who pay the largest share of taxes), affects the level of tax receipts. Therefore, the Federal Reserve needs to carefully consider how their decisions might affect stock market performance. If markets continue to fall significantly as they have done in early 2022 and there is a knock-on effect on tax receipts, this will exacerbate the already significant debt problem in the US.

Balancing a huge debt burden, rising inflation, recovery from a global pandemic and recent political developments is an unenviable task and there appears to be no consequence free solution to the problem. However, it is our view that tightening monetary policy in the current climate is a mistake on the part of the Federal Reserve and will likely lead to more downwards pressure on equity markets in what has been a challenging start to the year.

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[1] Source: FRED, Federal Reserve Bank of St. Louis.

[2] See our article, “US debt levels and the Role of the Federal Reserve”.

[3] Source: FRED, Federal Reserve Bank of St. Louis.

[4] Source: FRED, Federal Reserve Bank of St. Louis.