The Breakdown - RIP Transitory Inflation, Long Live Quantitative Tightening

Starting point is 00:00:04 Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexo.io, near NFTX, and produced and distributed by CoinDesk. What's going on, guys? It is Wednesday, June 1st. Welcome to a new month. Today, we are talking about the beginning of the era of quantitative tightening. Before we get into that, however, a couple housekeeping notes. You can find the breakdown in two places. The first is on the Coin Desk Podcast Network feed,

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Starting point is 00:01:45 off your pass. So today, as I mentioned, is the beginning of quantitative tightening. Some are calling it QT Day. But what does that mean? Well, since the global financial crisis, we have been in a period of extremely dovish, a historically dovish monetary policy. That period has featured low interest rates, what some call artificially low interest rates, designed to keep money flowing and economic activity happening. However, interest rates aren't the only tool the Fed has, and they certainly weren't the only tool that the Fed used in the wake of the GFC. The Fed also has its balance sheet. Quantitative easing refers to balance sheet increases where the Fed becomes a buyer of assets such as mortgage-backed securities and U.S. Treasuries. By buying these assets, the Fed is effectively

Starting point is 00:02:34 pumping liquidity into markets. This has been the dominant paradigm for the last decade. It has been the dominant paradigm throughout the entire history and rise of Bitcoin and crypto as an asset class. It has been a characteristic of the period in which capital has moved farther and farther out on the risk spectrum. It has been the dominant background characteristic of a world in which there been more money than flowing into things like venture capital and private equity. So much of what we know as normal now, ever-increasing valuations in private markets, for example, ever-increasing PE ratios in public markets, tons of emphasis on high growth and risky stocks like technology stocks. All of that has as background context this period of extremely Dovish monetary policy.

Starting point is 00:03:22 Now, at various moments, the Fed has tried to make a bigger shift out of Dovish monetary policy and out of QE, and the normal response has been for markets to freak the frick out. In May 2013, then Fed Chair Ben Bernanke said that at some point in the future, the Fed would begin tapering their asset purchases. In response, the markets threw an absolute hissy fit. Now, they did have some logic, right? In a world where the Fed is one of, if not the biggest buyers of bonds, investors quickly spotted that the Fed slowing their purchases would represent a major reduction in demand, which would cause bond prices to fall. In turn, yields would rise. So what did they do? Well, on mass, they started

Starting point is 00:04:02 selling treasuries to get out ahead of that Fed selling. This became known as the so-called taper tantrum, and was a uniquely reflective moment of the strange way that the Fed, monetary policy, and markets had become more interwoven in the teens. Now, as we try to understand the period that we're living through now, one thing that's important to note is that something that people expected to happen, but which didn't happen in the wake of the GFC, was a wide-scale consumer price inflation. Many people thought to themselves, oh, my goodness, they're printing so much money, we're definitely going to see inflation, and then that didn't happen. At least it didn't show up for consumers. This fact, the fact that consumer price inflation was expected and then didn't happen

Starting point is 00:04:44 shaped a lot of people's perspectives. And when the COVID crash came in 2020, they assumed we wouldn't see consumer price inflation either. Now, during this period, what we did see was a lot of asset price inflation. And this gets to the root of why markets care so much about what the Fed's policy is. Turns out that the liquidity from a major market buyer like the government was being is really good for asset prices. So when the Fed threatens to withdraw liquidity in the form of ceasing purchases of treasuries and mortgage-backed securities, or it actually does it, the market does not like that. Nexo lets you easily buy crypto with your bank card and earn industry-leading interest rates. Earn up to 16% on crypto and up to 12% on stable coins.

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Starting point is 00:06:19 Reimagined your world today at nere.org. The breakdown is sponsored by FTXUS. FtXUS is the safe, regulated way to buy and sell Bitcoin and other digital assets, with up to 85% lower fees than competitors. There are no fixed minimum fees, no ACH transaction fees, and no withdrawal fees. One of the largest exchanges in the U.S. FDXUS is also the only leading exchange that supports both Ethereum and Solana NFTs. When you trade NFTs on FTX, you pay no gas fees. Download the FTX app today and use referral code breakdown to support the show. Even before the COVID crashed, there were some signs of liquidity trouble. After the taper tantrum, it took them a few years to actually work up the will to start allowing the balance sheet to reduce. But by late 2017, they had in fact let the balance sheet start to shrink. Over the next couple years, the balance sheet shrunk by about $700 billion, and by the fall of 2020, it started to show some major signs of wonkiness around liquidity.

Starting point is 00:07:26 We'll talk about it in just a second, but there was a repo rate spike, which is the overnight bank-to-bank lending rate, that had people quite nervous in September 2019. Of course, we know what happened next. The pandemic came and it washed everything out, and we were back to extreme central bank involvement. The Fed facilities that were created in 2008 were revved back up in a major way, and this time the balance sheet growth was even more pronounced. As I mentioned, some were skeptical that even this level of monetary stimulus would lead to inflation based on their experience with the GFC. I remember discussing this with Hugh Hendry, who had been convinced that we would see consumer inflation after the global financial crisis, but then was very much shaped by the fact that that didn't

Starting point is 00:08:05 happen. Now, many others, of course, weren't convinced and were convinced in the opposite direction. Suter Jones' great monetary inflation thesis in May 2020 perfectly makes that point. Wherever people fell, the reality is, of course, that markets are always different, even if they look similar. This time around, in addition to that monetary stimulus, which was shared between the global financial crisis and the post-COVID crash, we had one fiscal stimulus that went directly into American pocketbooks, both in terms of cash injections as well as in terms of programs like loan deferrals, and two, a completely different factor in wide-scale shutdowns that had huge implications, not just in terms of supply chains, but also in terms of fundamental shifts

Starting point is 00:08:48 in patterns of consumer behavior and consumer demand. In short, the situation was different. In 2021, we started to see a rise in consumer price inflation in a way that we hadn't in the wake of the GFC. And that is what begat the transitory narrative of inflation that was pushed. by the Fed and administration officials for most of last year. Now, the transitory argument was that this particular inflation was driven by particular dislocations in the wake of COVID shutdowns. There were, of course, supply chain issues as factories had gone offline for periods of time and couldn't just get back up and running in the same way. And there were supply demand mismatches because there was so much pent-up demand for certain types of products, new demand for other

Starting point is 00:09:31 types of products that better fit a new type of consumer behavior, and so on and so forth. Now, even if those things were a part of what created this inflation, an inflation which has hit the highest levels in 80 years, it clearly wasn't transitory, at least on the time scale that it needed to be politically. With midterms coming up and people getting angrier and angrier about the growing cost of living, that transitory inflation was becoming a very real and very prescient political liability. What that meant is that as last year ended, there was a renewed focus from the Fed and from the administration on solving inflation and a consequent move away from the transitory language. This happened especially around November when Biden re-nominated Jerome Powell

Starting point is 00:10:14 as Fed Chair, and in December, when the FOMC meeting made it clear that the Fed was anticipating interest rates rising in 2022. Now again, remember, the Fed has two instruments broadly speaking, raising or lowering interest rates or increasing or decreasing their asset purchases, i.e. using their balance sheet as a tool. Around that time, in November or December, everyone in markets assumed and was frankly reassured that we were seeing a bit of a shift in tone and that interest rates would rise. What market participants didn't expect was to see a shift from quantitative easing and balance sheet increases to quantitative tightening and balance sheet reduction on the menu as quickly as the Fed seemed to think it was coming. In January,

Starting point is 00:10:53 the notes from the December FOMC meeting were released, and they showed that the Fed was considering balance sheet reduction on a much faster time scale than they had after the last crisis. So let's talk about what those terms mean in practice. As we said, quantitative easing is another word for balance sheet growth, where the Fed is buying assets and thus injecting liquidity into the markets. QE is the dominant paradigm of our last decade. Quantitative tightening is the reverse where the Fed is reducing its balance sheet. Now, importantly, in modern practice, quantitative tightening hasn't actually involved the open selling of assets onto the market. Instead, the shift from QE to QT goes through a couple phases. The first is balance sheet normalization, where instead of increasing the number of assets

Starting point is 00:11:33 on the balance sheet each month, which the Fed has been doing to the tune of something like $80 billion per month since the beginning of COVID, the Fed holds the total amount of assets on their balance sheet consistent. So what that means is that when a bond they own comes to maturity, they replace it with a similar size commitment, but they're not increasing the number of those bonds overall. The next phase, once balance sheet normalization has happened, is that they actually allow bonds to expire without replacing them. This is the main way in which balance sheet reduction happens. Another word they use for it is runoff. Mortgage-backed securities or treasuries come to maturity, and they don't replace them, and thus the balance sheet shrinks. Now, theoretically, they could try and

Starting point is 00:12:12 sell directly into the open market, although that brings up questions of whether there would actually be buyers for these assets. But either way, be it direct selling or the more passive expiration and runoff process, the net effect is the same, a removal of liquidity from the system. Many market participants have never lived through a period of the Fed withdrawing liquidity, and so there is a ton of consideration and concern around what happens next, and that's why this is a big deal. So what's actually happening is that the period of QT is officially opened, but the first assets will mature without being replaced in the middle of this month on the 15th.

Starting point is 00:12:46 To give a sense of the scale that we're talking about, the Fed's balance sheet currently stands at $8.9 trillion, roughly double what it was before COVID. The balance sheet reduction is slated to happen at a pace that is, twice as fast as the last financial crisis. The first maturity without replacement is 15 billion in treasuries that mature on the 15th, and in total, they've set a monthly cap for the runoff at 47.5 billion. So for June, July and August, up to $30 billion worth of treasuries and up to $17.5 billion in mortgage-backed securities will be allowed to run off the balance sheet,

Starting point is 00:13:20 expire without being replaced. In September, the thresholds doubled to a combined $95 billion in possible balance sheet reduction per month. When the Fed last tightened in 2017, the peak that they allowed was $50 billion a month. By the way, again, just for a timescale, note that after 2008, the Fed didn't stop buying until 2014 and didn't stop shrinking their balance sheet until the end of 2017. That means the period between crisis and balance sheet reduction was nine years, whereas this time it's happening just a couple years after the beginning of the pandemic. It's clear that the Fed is hedging a little bit in terms of its communication about this. this. Bloomberg is calling it an experiment and saying, quote, officials are uncertain about the market

Starting point is 00:14:01 impact of accelerated runoff. Fed Reserve Governor Christopher Waller said that the estimates of impact are, quote, highly uncertain. Recent FOMC meeting minutes noted, quote, regarding risks related to the balance sheet reduction, several participants noted the potential for unanticipated effects on financial market conditions. Other market commentators are more sure. Travis Kling tweeted this morning, happy quantitative tightening day, everyone. How long will the Fed shrink its balance sheet this time before it stops. He ran a poll where with nearly a thousand respondents, 46.9% thought this would only be a six-month thing. 30.6% said six to 12 months, 11.5% said a year, and 11% said two years. So what's the argument here? Why would the Fed shift and stop shrinking its balance sheet?

Starting point is 00:14:45 Well, one factor is if the Fed solves inflation but causes a recession. For a lot of folks, this is their base case. They expect then that the Fed will have to shift gears once again and come back with more market support. Another factor is assessments of a rickety system. Will removing liquidity cause more weird dislocations like the overnight repo rate in 2019? When the overnight lending rate spiked as high as 10% and still financial institutions with extra cash refuse to lend? Yet another factor is the reaction of the stock market. How much can they handle prices cratering? Or put differently, how low will the Fed allow them to go? There is, of course, another dimension of this which is more specific to the mortgage-backed security side of the equation. The Fed hasn't taken off the table

Starting point is 00:15:27 the idea of selling MBSs directly back into the market. And of course, there could be some damage if the market can't absorb this. Adam Cochran writes, what to worry about this time is the amount of mortgage-back securities. These have longer payback times than bonds, and so the reality is you can't just wait for those to run off the books. At some point, you have to sell. MBSs are bonds that are backed by mortgage and real estate loans, which as rates rise, the housing market cools, and Americans get squeezed on inflation are much less attractive securities. The problem becomes that they will likely have to sell these at some point, and it's not exactly clear that there are willing buyers, at least not at any reasonable price point.

Starting point is 00:16:02 The Wall Street Journal describes it as such. Analysts worry that fed sales of existing bonds could flood the market, driving down prices and pushing yields higher as bond investors demand more compensation to lend money. That would boost mortgage rates because bond yields act as benchmarks for real estate lenders. So whatever happens next, this is a clear and real moment of transition. Times have changed. To put a capstone on this yesterday in a CNN interview, Treasury Secretary Janet Yellen said, quote, I think I was wrong about the path that inflation would take. There have been unanticipated and large shocks to the economy that have boosted

Starting point is 00:16:36 energy and food prices and supply bottlenecks that have affected our economy badly that I didn't at the time fully understand. For what it's worth, I've seen a lot of dunking on Yellen's comments. Personally, I think we should encourage politicians to say I was wrong more. They shouldn't be rewarded for being wrong, and it's still totally reasonable to say, you got this wrong, and that impacts how I think about your judgment. But I believe the ability to say I was wrong, and to shift course appropriately, would likely lead us to a healthier place overall. In either case, I think that we can officially declare the era of transitory inflation over and the era of quantitative tightening begun. For now, I want to say thanks again to my sponsors, nexo.io, near NFTX. And thanks to you guys for listening.

Starting point is 00:17:21 Until tomorrow, be safe and take care of each other. Peace. Hey, breakdown listeners. Come join CoinDesk's Consensus 2020, the festival for the decentralized world this June 9th through the 12th in Austin, Texas. This is the only festival showcasing and celebrating all sides of blockchain, crypto ecosystems, Web3, and the Metaverse and is designed for crypto-newbies, investors, entrepreneurs, developers, and creators. Use code breakdown to get 15% off your pass at coindesk.com slash consensus 2022.

The Breakdown - RIP Transitory Inflation, Long Live Quantitative Tightening

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