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Where is the end of the Fed’s balance sheet reduction?

  Since March this year, the Federal Reserve has raised interest rates six times in response to rising inflation. At present, the question that the market cares about is: When will the interest rate cut start, and what is the triggering condition? Will the shrinking of the balance sheet be accelerated, and where is the end point?
  As Yellen said, there is no preset path for monetary policy. In the post-epidemic era, the volatility of macroeconomic operations has increased significantly, and the decisions of the Federal Open Market Committee (FOMC) must also be based on actual data rather than model forecast data. Instead of basing their transactions on vague forecasts that need to be constantly revised, investors should simplify the complexity and step by step, starting from the “dual mission” of the Federal Reserve, and grasp the main contradiction of inflation and the main concern of “insufficient austerity”.
  Relevant market analysts believe that as long as energy and food prices no longer hit new highs (or the growth rate slows down), it will be difficult for overall inflation to exceed the previous high (9%). However, the trend of inflation still has upward momentum, mainly because the service industry is still in a high boom range. From January to September 2022, the U.S. ISM-PMI index has always been in the boom range. Among them, the non-manufacturing and business activity PMI indexes are both higher than 55, and the national economic activity index constructed by the Chicago Fed has also changed from a negative value range from June to July. bounced back into positive territory. The labor market is still “very tight”, and the wage increase measured by the Employment Cost Index (ECI) may be marginally slowed down, but will remain at a high level. Although interest rate hikes have reversed the upward trend in house prices—the inflection point will appear in June 2022, there is still a time lag of about 13 months in its transmission to rents. In his latest speech, FOMC Director Waller predicted that the upward pressure on rents will continue until 2023. Therefore, inflationary pressures in the service sector will continue to exist.
  On the whole, although there are some signs of optimism in terms of inflation, it is far from the time for the Fed to change its policy stance. One potential risk that has to be guarded against is the “wage-price spiral”. If there is a strike wave of blue-collar workers, the risk of a repeat of the Great Stagflation will increase significantly. The Fed must keep monetary policy “overtight” for some time until the trend of inflation is reversed.
  Generally speaking, when the FOMC judges that the federal funds rate (FFR) has reached an appropriate level, it will adjust the progress of shrinking the balance sheet according to the liquidity situation, first reducing the scale of shrinking the balance sheet step by step, and then stopping the shrinking of the balance sheet. After a while, the Fed’s balance sheet will enter a stage of endogenous growth. To observe the problem of shrinking the balance sheet at the technical level, it should be transferred from the asset side to the liability side, focusing on the scale of reserves. According to the experience of shrinking the balance sheet from 2017 to 2019, FOMC director Waller believes that the ratio of reserves to GDP reaches 8% can be used as a frame of reference for the appropriate size of reserves. The level in June 2022 is 12.8%, down 5 percentage points from the peak in September 2021 (17.8%), mainly due to the increase in the scale of reverse repos. As of early October, the broad liquidity (reserves + reverse repos) was still as high as US$5.6 trillion, accounting for 22% of GDP.
  Based on the data at the end of September 2022, according to a rough calculation based on the monthly shrinkage rate of US$95 billion, it will take 2.5 years to absorb the generalized liquidity of US$3 trillion to reach the threshold of 8% of the ratio of reserves to GDP value. This means that the end point of shrinking the balance sheet may be in the first half of 2025 (8.9% at the end of the first quarter and 7.8% at the end of the second quarter). Assuming that the time to end the rate hike is 2023 (any time), it is unreasonable to end the balance sheet reduction in the first quarter of 2025. The experience from 2018 to 2019 is that the interval between the two should not exceed one year. This time it may be shorter, and the end of the balance sheet reduction will move forward as the end of the interest rate hike moves forward.

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