The authors are economists from Shinhan Investment Corp. They can be contacted at [email protected] – Ed.
Reasons for the Fed’s earlier-than-expected quantitative tightening
Discussions on quantitative tightening have started among members of the US Federal Reserve, as reported in the December 2021 FOMC meeting minutes. This has increased volatility in the financial market. The Fed is now likely to begin quantitative tightening in 2H22, earlier than expected in 2024. An earlier tightening compared to past episodes of monetary policy normalization is attributable to the difference in how liquidity was created. The current excess liquidity has been generated by a combination of the government’s fiscal expansion and the Fed’s quantitative easing, and can therefore be controlled more effectively by quantitative tightening rather than rate hikes.
Outlook on the pace of quantitative tightening and rate hikes
We expect the Fed to begin quantitative tightening within three to six months of its first rate hike in 2022, based on FOMC minutes. Assuming a first rate hike in March, tightening should begin in June at the earliest. The Fed is expected to absorb excess liquidity levels at mid-USD over a period of about 21 months by shrinking its balance sheet at a rate of $ 80 billion per month. We believe the Fed will slow the pace of rate hikes during quantitative tightening because: 1) inflation will stabilize through liquidity control; and 2) the low interest rate policy must be maintained to support budgetary spending.
With the withdrawal of excess liquidity, future liquidity depends on the creation of credit
The excess liquidity, which has led to an overall surge in asset prices, will be absorbed by quantitative tightening. While the absolute level of liquidity will remain the same until 1H22 before the expected tightening in 2H22, we expect to see a style rotation with changes in risk premiums. Liquidity conditions from 2H22 should depend on credit creation. If credit is created in large quantities with increasing investments, market liquidity should increase despite the reduction or stagnation of the M1 money supply caused by the quantitative tightening.