QNB Group has reiterated its expectations of two rate hikes from the US Federal Reserve (Fed) this year, starting in the first half of 2017. The Fed is unlikely to start reducing its balance sheet before mid-2018, QNB noted in its weekly economic commentary, yesterday.
QNB believes that macroeconomic conditions warrant two Fed hikes. The US economy is expected to grow by 2.0 percent this year. This should reduce the unemployment rate by 0.2 percent to 4.5 percent at end-2017 compared to a year earlier and core inflation is expected to rise by 0.1 percent to 1.8 percent over the same period. Using the Fed’s standard rule linking interest rate decisions to inflation and unemployment (the so-called Taylor Rule), the magnitude of improvement in economic conditions suggest two rate hikes. Financial markets are in line with this logic, as they are also currently pricing in two rate hikes.
Encouraged by recent strong data on retail sales and consumer price inflation, markets have revised up the probability of a rate hike in the next meeting in March to 80 percent, up from 24 percent three weeks ago. However, the Fed may decide to wait until May or June, as this would give them time to get more clarity on Trump’s economic policies and how they might impact the economy. Whether the actual hike would happen in March or three months later in June would not matter a great deal, especially if the total number of rate hikes is left unchanged. More importantly, and potentially more disruptive for financial markets, is the third question about the Fed’s balance sheet. After the Fed pushed short-term interest rates close to zero in late 2008, its main tool for tackling the recession became reducing long-term interest rates through multiple quantitative easing (QE) operations. These involved purchasing large quantities of government bonds and government-backed securities, which resulted in the Fed’s balance sheet ballooning from around $900bn to about $4.5tn currently. QE was exceptional in its scope and size and was always expected to be unwound at some point.
According to QNB analysts, reversing QE would increase long-term interest rates, which could provide an alternative method of monetary tightening compared to controlling short-term rates. This should prove particularly attractive as the US dollar is less sensitive to long-term rates than short-term ones, which means that reversing QE could provide the required tightening in lending rates without the associated appreciation of the dollar which hurts exports. In addition, the size and the expansion of the Fed’s balance sheet have attracted political criticism and reversing QE could help fend off these attacks.
But there are also arguments against unwinding QE too soon. First, despite the Fed’s best intention to use “reverse QE” as an alternative to interest rates, markets might interpret the rush to reverse QE as an indication that interest rates would rise at a faster pace than expected. This would lead to a stronger dollar and trigger capital flight out of emerging markets, exactly the same dynamics that unfolded in 2013 with the “taper tantrum”.
Second, the impact of both QE and its reversal are less well-understood than that of short-term interest rates. The Fed might want to build up sufficient space to allow it to reduce interest rates meaningfully should reversing QE have negative consequences. Hence, the Fed’s insistence that unwinding its balance sheet will not begin until the tightening of interest rates is “well under way”. Third, despite political criticism, there is little evidence showing that a large central bank balance sheet is harmful for the economy. Central banks in the UK, Japan and Switzerland all maintain larger balance sheets than the Fed relative to the size of their economies. Yet there are few if any negatives associated with maintaining large balance sheets in these countries.
“In light of these arguments, we do not think the Fed will rush to reverse QE and reduce its balance sheet. We do not expect this process to begin until sometime in 2018''.
