As the Fed and other central banks signaled their hawkish stance, there was an inversion of the yield curve, where rising short-term rates rose more than long-term rates.
This inversion, as we and others have explained, is a sign that a recession may be looming in the future, as it implies that rates will rise and then have to come back down as growth slows or slows. reverse.
This nasty inversion
It now appears that another, arguably more powerful, way to tighten financial conditions is to scale back purchases of long-term bonds, and to do so earlier and faster.
London-based FX specialist Francesca Fonsari of Insight Investment highlighted a political debate over the appropriate tightening mix, with a strong case for QT over rate hikes.
Why? Well, it comes down to the yield curve. The problem with a flat or inverted yield curve, Fonsari explains, is that it discourages banks from lending money.
Indeed, their core business – which is to borrow money short-term (via deposits) and lend it long-term (via loans) – is all the more profitable the higher the long-term rates. , relative to short-term rates. . The steeper the yield curve, the more banks will lend.
Central bank bond purchases were aimed at lowering long-term borrowing rates and reducing those in absolute terms.
But if short-term interest rates rise too quickly relative to those long-term rates, the banks that are the conduit for lending to the economy will pull back.
This potentially unnecessary phenomenon suggests that the Fed might be better off doing more quantitative tightening than rate hikes.
QT would raise mortgage rates in absolute terms and slow consumption to counter inflation. But it would also maintain the slope of the yield curve, and therefore secure the flow of credit in the economy, facilitating capital investment.
It should be noted that the US financial system is different from the Australian system in that US mortgages tend to be fixed at a 30 year fixed rate, whereas almost all Australian mortgage rates are variable or fixed for three to five years.
This means that the US consumer, and by extension the US economy, is more sensitive to long-term borrowing costs than the Australian consumer, and the political calculus is different.
So what is the optimal combination of rising rates and reducing bond purchases?
The reality is that we are in uncharted waters, says Fonsari. It was only a decade ago that central banks, faced with the zero boundary, resorted to bond purchases in an effort to provide the stimulus the market needed.
One of the most sought-after consequences of quantitative easing was to drive up the value of risky assets such as stocks. Now, as Brainard’s hawkish comments made clear, the reversal of this process must be accelerated.