Conventional wisdom suggests that in a typical tightening cycle the Fed raises rates until something breaks. Then, the storyline goes, a policy pivot begins — reluctantly at first, but eventually with a whole lot of vigor. The timing and market source of this proverbial pivot have become the primary focal points of nearly all of my recent client discussions. In fact, the only topic which has received as much attention is my possible hat logos for 2023. For the moment I’m still undecided on the hat front, so let’s leave that aside. Instead, I want to discuss this financial instability-based pivot concept.
In a nutshell, I think the whole idea is basically rubbish. The Fed is not going to give up either anchoring long-run inflation expectations or bringing down the current high levels of spot inflation just because some corner of the capital market moves into a state of distressed forced selling. Like other major central banks, the Fed will simply use its balance sheet to deal with any financial instability, while sticking with its fight against inflation pressures.
To that point, let’s consider the recent action taken by the BoE in response to the LDI-related forced selling at the long end of the gilt market. The BoE saw the problem, created a balance sheet-driven purchase facility to support the systemic selling pressure, and then went on its merry way with tightening guidance and actions. This week short rates will rise, and QT will kick off in the front end. There was no BoE pivot in response to this rather serious bout of financial instability. In the end, a balance sheet facility was created to solve the problem, and the path for overall monetary policy accommodation removal remained unaltered.
Let’s also go back in time to the ECB’s creation of the antifragmentation tool. As it became clear that a monetary tightening was desperately needed for Europe earlier this year, the ECB knew safety guards would be required for the BTP market. Without some form of backstop, spreads would explode wider as the tightening kicked off. To keep spreads in check, the ECB created an opaque but effective facility to purchase BTPs even as rates rose, and QT began in other government bond markets. The ECB was not about to let BTP-related systemic fragility force an unwanted pivot in their tightening efforts. Once again, balance sheet policies were created to solve the financial instability problem, while the path for overall monetary policy accommodation removal remained unaltered.
So, if something starts to break in the US capital markets, should we expect the Fed to pivot its overall monetary policy stance? NOPE!! The advent of unconventional monetary policies beginning in 2008 ushered in a period of central bank versatility. They don’t have just a single rate lever to operate when it comes to both monetary and financial stability policies. They can create funding facilities, swap facilities, or purchase facilities at a moment’s notice. And it doesn’t have to occur only at the effective lower bound for short rates. Facilities can be created just as easily when rates are rising. The BoE and ECB have already shown us exactly that.
The key point here is that a financial instability-induced policy pivot is an ill-conceived concept. Many folks seem to believe we are stuck back in the ’90s, when central banks had not yet developed balance sheet tools. Recall that in 1998 when the LTCM crisis hit financial markets, the Fed didn’t use its balance sheet to counterbalance the forced selling and instability. Instead, they cut short rates three times. They pivoted!! Sadly, that was in an economy with low unemployment, low inflation, and a 4% real GDP growth rate. The last thing the overall economy needed was rate cuts, but financial instability and a lack of alternative tools forced their hand. And while the cuts helped stop the LTCM crisis, they also pushed healthy parts of the financial markets into bubble territory (cue the QQQs). Blanketing the entire system with stimulus was a blunt way to solve the problem, and it created much larger imbalances down the road.
Today central banks don’t need to apply such a coarse response to systemic flare-ups. The advent of balance sheet tools allows for precision targeting. The Fed can now operate with laser-like focus via the balance sheet to remove these risks without compromising the overall stance of monetary policy. The technological advances in monetary policy since 2008 have changed the conventional wisdom around this financial stability-based pivot narrative
So, when we discuss any policy pivots today, it’s far more important to look at metrics that relate to the dual mandate rather than financial instability. And to that end, with the Fed having anchored inflation expectations successfully throughout the course of this year, we are likely coming in toward the final stages of this tightening move. After this week, there will have been 400 bps of short rate tightening. And by the end of the year, we will likely have 450/500 bps in the kitty. Add to that $95b per month in QT, and this Fed will start to seriously consider the long and variable lags associated with this very aggressive tightening.
To that end, a lot of the heavy policy lifting has already been done. And the Fed will not need a financial instability excuse to pivot toward a period of rate and QT stability. They have done an incredible job with the anchoring of inflation expectations throughout these two years of extremely high spot inflation. This will earn them a chance to sit back and watch the data for a bit in early 2023 before fine-tuning policy in response. This upcoming policy pivot will have nothing to do with financial instability, rather, it will come from a successful anchoring of long-run inflation expectations. Good luck trading
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