Fed capacity to tighten constrained without tackling deficits - SocGen

FED CAPACITY TO TIGHTEN CONSTRAINED WITHOUT TACKLING DEFICITS - SOCGEN (0854 EST/1354 GMT)

As investors focus on how high the Federal Reserve will hike rates and how much quantitative tightening there will be, they are paying less attention to a key driver of the current inflation problem – government spending and the potential Fed monetization of government debt.

Societe Generale analysts led by Solomon Tadesse said in a report this week that until deficits are reined in, the limits of monetary policy will be constrained, and each new spending spree that comes after a recession can make the problem worse.

“Years of debt-financed budget deficits and increasing reliance on potential debt monetisation may have eroded the monetary policy space, constraining central banks’ ability to raise policy rates without triggering a recession.”

For example, they note that Paul Volcker was able to hike rates as high as 19% in the early 1980s without causing a recession, while in 2018 “it only took a mere 2.5% hike to cross the hard-landing threshold.”

“For markets, brute force monetary tightening without concomitant fiscal discipline that significantly slashes budget deficits and debt financing may only provide a temporary reprieve, if any at all,” they said.

The Fed has increasingly relied on quantitative easing and a larger balance sheet for monetary easing, but with each new round of fiscal spending and Fed bond purchases the problem can become more difficult to dig out of.

When the Fed buys bonds and enlarges its balance sheet the potential for debt monetization increases, which can boost inflation. It also reduces its future flexibility to tighten.

“Reliance on QE and central bank balance sheets tends to exacerbate the depth and frequency of subsequent crises, particularly when dealing with an exceptional concomitant crisis such as the 2020 pandemic,” the analysts said.

The United States government ramped up spending in response to COVID shutdowns, and the national debt held by the public has soared to $24 trillion, from $17 trillion in early 2020. Fed bond holdings are currently at $8.58 trillion, up from $4.15 trillion in Jan 2020.

Societe Generale estimates that if the amount of debt held within the Federal Reserve system were reduced to 10% of GDP, from 25% now, the Fed could shrink its balance sheet by around $4.36 trillion, which would reverse almost all of its pandemic quantitative easing.

(Karen Brettell)

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