Quantitative Easing to Quantitative Tightening

On March 22, 2018, BNY Mellon Asset Management’s Chief Economist and Investment Strategist Vincent Reinhart spoke at SAA’s Insurer Investment Forum XVIII to discuss his economic forecast during this transition period of Quantitative Easing to Quantitative Tightening.

Here are a few of the highlights. You can view the presentation slides here.

On Emerging Market Growth:

The slowing of potential output growth implies rates will remain low. That’s something you must appreciate when assessing balance sheets. Looking across the world, everybody’s growth is slow. The IMF, over the last five years, marked growth lower in 9 out of every 10 countries. But, it’s growing faster in emerging markets, relative to more advanced economies. There are opportunities for higher rates and returns, but that’s got to include emerging markets; it’s a strong argument for diversification.

On Growth in Advanced Economies:

Across advanced economies, the data has mostly been positive and expected to stick. U.S. Equity prices have moved a lot and the 10-year treasury has backed up, but the dollar is depreciated and equity prices are much higher the last three years. This is a different kind of “tightening cycle” for the Federal Reserve, because financial conditions are more accommodative today.

In Europe, they have the benefits of the early dollar appreciation, which depreciated the euro. In this environment, what matters is potential output growth. Since potential output growth has slowed, it implies that “above-trend” growth works down the output gap. According to the Congressional Budget Office the United States worked off its output gap in labor markets about two quarters ago and in product markets last quarter.

On the Federal Reserve and Tightening Policy:

As for monetary policy in the U.S., we think the Fed is going to tighten four times in 2018 and twice in 2019. One reason is we’re in a state of excess demand; cost pressures are rising and inflation will rise. The unemployment rate is at 4.1% right now and is expected to be around 3.5% by the end of this year. FOMC members expect inflation to be above 2% in 2018 and 2019. They’re going to overshoot their goal, which is also why we think they are going to be tightening monetary policy for a while.

As Jay Powell is not an economist, he tends to trust models less. He’s backed away from formal models, economic projections, forecast of interest rates. If Jay Powell does rely less on models, it implies he does not think of one aspect of unconventional policy is as useful right now, like interest rate guidance. He’s going to be more reactive to what the data says at a given time.

With QE, you get the implication that longer-term rates are lower and, by expanding the size of the Fed’s balance sheet, the Federal Reserve has a lower term premium. In that environment, it depends on how quickly the Fed unwinds its balance sheet accommodation to know how that will get priced through financial markets.

Jay Powell is clear on their plan of rising caps on the amount they can reinvest and that will involve the shrinkage of the balance sheet over time by letting some of maturing holdings, treasury securities and MBS essentially disappear. The caps are set on a quarterly schedule and implies that by March 2022, the Federal Reserve will lower its balance sheet to about $2.5 trillion. The shrinkage of the Fed’s balance sheet will be a force over the next 3-5 years, so while we might not figure out how to get potential output growth faster, the balance sheet will be an additional pressure on rates. The Federal Reserve is probably going to tighten monetary policy until the real short rate gets into the neighborhood of 1% or 1.25%.

On U.S. and China’s Trade Relationship:

The U.S. sends about $1.25 trillion in exports to China. China sends about $5 trillion in goods. Hence, it’s a bilateral balance around $375 billion. That trade is, on the export side, very concentrated towards soy beans, aircrafts and cars. On the other side, China sends various goods to the U.S., with 14 types of imports crossing the $10 billion mark. China makes up more than half of imports to the U.S. What that implies is that, while this current administration can put a sanction on various places to raise $60 billion, if China retaliates it will be very concentrated. From an economic standpoint, a tariff will be tough for the Central Bank to respond to. Demand is affected, but costs are raised. There’s no obvious monetary policy in response. The Federal Reserve must worry about higher cost pressures. Trade is something worrisome and a source of uncertainty for the longer-term outlook.

On Expectations from Volatility:

Central Banks have crushed volatility. It’s also the view that Central Banks’ tolerance for market shock is much less after various financial crises. It is not just that volatility is low; it is the mean reverting to that low level any time it spikes. Importantly, it’s a function of two things: Central Bank action and the slowness of trend growth. The Federal Reserve is the first to get out, with the ECB and Bank of Japan only a few years behind.

On Debt Levels of China and the U.S.

Episodes of economies with debt-to-GDP ratios being above 90% are rare; only 26 of them. Relative to the economy’s history, growth was about 1.25% slower per year while in an episode of very high debt. China is growing at 6.5%, because it has been willing to lever its national balance sheet. They also suppress crises, which is going to be an issue long-term. Can they continue their growth model for the next 10 years? That is material risk of a long-term outlook.

The U.S. currently has excess demand and the unemployment rate is trending lower, creating even more pressure on resources. When in a state of excess demand, that is the time to build up resources for the government, like narrow the budget deficit, but the U.S. is doing the reverse. It will be a couple years in a row of $1 trillion deficits, even as the population ages, the ability for higher returns trend down and the claims on resources increase.

On Risks to Forecast

The risks are symmetric. Jay Powell is a new Fed Chair. If they see inflation overreaching his goal, that could get messy. If we see a couple months in a row where inflation is on the upside we could get an outbreak of inflation jitters. That will test the Fed Chair, which might mean inflation jitters, backup in yields, picking up the pace in tightening. If problems escalate with China, things could get out of hand. That’s not the forecast, but certainly a risk.