The Fed will struggle to tighten without turmoil

Markets’ rocky start to the year owes more than a little to the expectation that the Federal Reserve might hike rates over the coming months. By the end of the year, it might also shrink its vast balance sheet.

Given what happened to assets the last time the Fed engaged in monetary tightening, one can appreciate why investors are jittery. As this chart from the excellent Jim Reid of Deutsche Bank highlights, the last period of Fed tightening, in 2017/18, was followed by the highest ever proportion of asset classes recording negative total returns. Eeek:

As Reid puts it:

Timing is near impossible to get right without a modicum of good luck but if the Fed do embark on as aggressive a series of rate hikes and QT, as is looking likely, then at some point the probability of major market corrections across the board are likely.

There may be even more tumult this time around.

Debt burdens are now substantially higher. The Institute of International Finance’s Global Debt Monitor measured global debt at just shy of $300tn, or 350 per cent of GDP, in the third quarter of 2021. Up from around $250tn, or about 320 per cent of global GDP in 2018.

Add to this the wave of activity in more shadowy sectors such as crypto, and it’s not hard to imagine that an awful lot of people, businesses and governments are leveraged to the hilt. Even relatively small changes in the price and quantity of credit could have a major impact on prices. As margin calls are made, a vicious circle of fire sales — and further calls — could ensue.

On top of this, there’s another risk. If inflation endures, the size and pace of Fed tightening may exceed current expectations.

The federal funds rate is now about eight percentage points lower than it was the last time inflation was north of 6 per cent:

That’s before we get to the rise in size of the balance sheet. Here’s how it’s ballooned since the Fed’s current time series began in 2002:

It might be well be the case that, with debt being as high as it is, credit might not need to be as costly as in the past in order to dent demand and tame inflation. But, as Edward Price warns here, the right federal funds rate for the real economy may still be far higher than markets can stomach.

With the Greenspan put nearing its 35th birthday, the assumption that the US’s monetary policymakers will undo tightening if there’s market turmoil is baked into investors’ mindsets.

But nothing lasts forever. Decades of low inflation have given the US’s central bankers room to soothe investors’ nerves. At some point, price pressures will become endemic. When they do, the Fed’s tune might change in a more radical way than markets expect.