Nomura's Gu Chaoming: "Monetary Policy in Europe and the United States 'Fails,' QT Has No Effect, the Federal Reserve Will Continue to Raise Interest Rates"

With Federal Reserve Chairman Powell's "hint" at the Jackson Hole Central Bank Symposium that further rate hikes may be possible, and European Central Bank President Lagarde's statement in an interview that "pausing rate hikes is not the end," market expectations for rate hikes have once again heated up, leading to increased uncertainty.

On August 23, Nomura Securities' Chief Economist Gu Chaoming pointed out in a report that the statements from the two major central banks in Europe and the United States indicate that they both lack certainty about the economic outlook and will adjust policies based on economic data. This may mean that the effectiveness of monetary policy is declining.

Gu Chaoming believes that Powell had previously explained the slow response of the economy to multiple rate hikes with the concept of "long and variable lags" in monetary policy, meaning that "it takes time for rate hikes to impact the economy." However, economic data has not confirmed this point, but instead suggests that the Federal Reserve may further raise interest rates:

During the period of deflation from 2008 to 2021, the Federal Reserve attempted to stimulate economic growth and inflation through bold monetary easing policies and implemented large-scale quantitative easing.

However, it was not until 2021 when the United States began to emerge from the most severe period of the pandemic that these measures began to boost inflation rates.

At that time, some policymakers also cited the "long and variable lags" in monetary policy as the reason why these measures seemed ineffective. But their failure to achieve their self-set inflation target after 13 years indicates that the actual "lag time" has already exceeded 13 years.

He pointed out that these experiences suggest that the reason why monetary policy is not effective may be the reduced effectiveness of the policy itself, rather than the so-called "long and variable lags":

Essentially, his (the policymaker's) view is that it takes time for rate hikes to impact the economy, and the required time varies depending on the situation.

I think what we need to ask is whether this is true.

Gu Chaoming believes that the current monetary tightening policy has not produced substantial results, and the U.S. financial environment remains loose, so the Federal Reserve is likely to continue raising interest rates.

In addition, he believes that the Federal Reserve not only has the responsibility to control inflation but also faces the challenging task of reducing excess reserve interest rates. This means that the pace of the Federal Reserve's quantitative tightening will continue to be stable, which is consistent with the statement in the July minutes of the Federal Reserve that "even if interest rates are lowered next year, QT will continue."

The Consequences of Excessive Easing

Gu Chaoming believes that an important reason for the failure of monetary tightening policies is the "abuse" of loose policies, leading to a vicious cycle.

Central bank monetary policy typically relies on two tools: interest rate control and liquidity supply. Gu Chaoming pointed out that the efforts of then Federal Reserve Chairman Volcker in 1979 to curb inflation were successful precisely because he limited the supply of liquidity.

At that time, American banks had almost no excess reserves, and when the Volcker Fed reduced the supply of these reserves, banks took action to retain more reserves. This led to the federal funds rate soaring to 22%, weakening the economy and stabilizing inflation.

However, today, the long-term implementation of quantitative easing has resulted in the US having approximately $30 trillion in excess reserves, 1600 times the amount before the collapse of Lehman Brothers. This means that the Federal Reserve no longer has the option of tightening monetary policy by reducing liquidity supply. The only way to tighten policy is to raise interest rates.

Under normal circumstances, banks have three options to obtain more reserves: competing for deposits, obtaining funds from the interbank or bond market, or borrowing directly from the central bank. Each of these options involves borrowing costs.

Gu Chaoming pointed out that it is precisely because of these costs that the central bank's monetary tightening policy can be effective.

But in today's United States, excess reserves are 1600 times the amount during normal periods, which means that banks essentially have "unlimited" funds to lend - as long as there are borrowers, they have the ability to increase loans without any of the three borrowing methods mentioned above.

In this situation, monetary authorities cannot expect tightening policies to be effective unless they deter borrowers by raising interest rates to levels far above normal.

At a time when the central bank is implementing monetary tightening, excess reserves are at an unprecedented level in history. However, there are no examples from the past that can tell us how much interest rates need to be raised for tightening policies to have the expected effect.

In addition, a year ago, the FOMC members' "dot plot" for the US policy rate did not anticipate the need for the Federal Reserve to raise the federal funds rate to its current level, and there is still the possibility of further increases.

Despite the rapid pace of interest rate hikes, the economy has shown resilience, and the real estate market has even rebounded, indicating that the Federal Reserve has not achieved the tightening effect it sought.

Gu Chaoming said that in this sense, both the central bank and the market continue to "grope in the dark":

(They) are trying to determine the appropriate level of interest rates in the presence of massive excess reserves in the system. This is why the Federal Reserve and the European Central Bank cannot provide any forward guidance.

Quantitative tightening is "ignored"

Quantitative indicators show that the current financial conditions in the United States are even looser, which means that the Federal Reserve's quantitative tightening policy has little effect.

In the week ending August 18, the National Financial Conditions Index (NFCI) calculated by the Chicago Fed was -0.40. When this index is positive, it indicates relative market tightness or higher risk sentiment, and when it is negative, it indicates that the market is still loose.

The latest indicators above indicate that despite multiple interest rate hikes by the Federal Reserve, the US economy remains looser than the average level of the past 50 years.

Gu Chaoming pointed out that despite the rapid tightening of policies, the index has not even once fallen into negative territory in the past year.

In addition to interest rate hikes, the Federal Reserve is also reducing its holdings of US Treasury bonds and mortgage-backed securities (quantitative tightening, QT). However, Gu Chaoming pointed out that the starting point of its balance sheet is $8.48 trillion, about 17.7 times the size before the bankruptcy of Lehman Brothers, and the scale of monthly reduction by the Federal Reserve is $95 billion.

At the current pace, it will take at least 5 years for the Federal Reserve's balance sheet to return to "normal".

Although the speed of QT implemented by the Federal Reserve since October 2017 is twice as fast as the previous time, and Powell has repeatedly reminded market participants of the ongoing reduction of the balance sheet, the market has basically ignored it.

Gu Chaoming believes that the form of QT by the Federal Reserve is to stop reinvesting in maturing securities, and because it does not involve any direct market activities, it is often easily overlooked by market participants.

At the same time, they also overlook the fact that this QT has the same impact on the bond market as the issuance of new US bonds, that is, it increases the supply of bonds:

Currently, the monthly expansion rate of QT by the Federal Reserve of $95 billion is equivalent to $1.14 trillion per year, which is approximately three-quarters of the projected $1.539 trillion federal deficit for fiscal year 2023.

If QT does not work, it may be due to one of the following two factors:

1. Market participants are not aware that the impact of QT on the bond market is similar to doubling the US budget deficit.
2. They have no other place to invest excess funds and use the excess liquidity provided by quantitative easing to purchase US bonds.

Gu Chaoming pointed out that regardless of the situation, the yield of 10-year US Treasury bonds has fluctuated mainly in the range of 3.5% to 4.5% since it rose above 4.2% in October last year, despite the implementation of QT and rapid interest rate hikes since then. This indicates that monetary tightening may no longer be as effective as it used to be.

If both interest rate hikes and QT fail to raise long-term US bond yields, it indicates that the Federal Reserve will need to further tighten policy through additional interest rate hikes.

As long as the US economy remains strong and the yield of 10-year US Treasury bonds remains within the current trading range, the Federal Reserve will have to consider further interest rate hikes.

The "Cost" of Quantitative Easing

Gu Chaoming pointed out that one reason the Federal Reserve wants to normalize its balance sheet as soon as possible may be the unique cost of quantitative easing - Interest on Excess Reserves (IOER).

Interest on Excess Reserves is the interest paid by the Federal Reserve to commercial banks as a return on the excess reserves held in Federal Reserve accounts. Excess reserves refer to the portion of reserves held by commercial banks at the Federal Reserve that exceeds their required reserves. This is a monetary policy tool used to adjust interest rates in the interbank market and the money supply in the market.

When commercial banks hold excess reserves, they actually deposit these funds in Federal Reserve accounts instead of using them for lending and investment. In order to make holding excess reserves attractive to banks, the Federal Reserve pays IOER as an interest, similar to the return banks receive when lending to other banks. By paying IOER, the Federal Reserve can influence the level of short-term interest rates in the market and the amount of funds banks put into the market.

Therefore, in order to achieve tightening, the interest rate paid by the Federal Reserve to commercial banks must be higher than the interest rate at which commercial banks lend to the private sector, to ensure that funds are no longer used for lending.

Gu Chaoming stated that the current total amount of these excess reserves in the United States is about $30 trillion, and paying 5.5% on the entire amount would cost $165 billion per year. The increase in this expenditure would reduce the amount the Federal Reserve pays to the government, which is a potential political risk for the Federal Reserve:

Reducing the income of the Treasury Department will increase an equal amount of fiscal deficit, and future taxpayers' bills will also increase.

Although market participants and politicians may not currently pay much attention to IOER, the Federal Reserve itself is almost certainly aware of this political risk. I suspect this is why it wants to proceed with QT as quickly and steadily as possible.

It should be noted that the $165 billion annual payment for excess reserves will increase the amount of excess reserves. This is obviously unfavorable for the Federal Reserve, which is trying to suppress inflation by reducing excess reserves.

Although the Federal Reserve has not announced the extent to which it plans to reduce excess reserves through QT, considering the potential cost of IOER and its potential to become a political issue, the Federal Reserve may want to reduce them to a fairly low level.

If the Federal Reserve sets its target at a relatively high level and leaves a large amount of excess reserves in the system, the amount of excess reserves it has to pay each year will be much larger.

Gu Chaoming emphasized that IOER is the "real cost" of quantitative easing and only becomes apparent when tightening begins:

This is the true cost of quantitative easing. The characteristic of quantitative easing - that the cost does not become apparent until authorities start raising interest rates - is a key reason why many policymakers are caught off guard.

As long as interest rates remain at zero, this policy will not incur any costs - after all, regardless of how much reserves are provided under quantitative easing, IOER will be zero. This is also the reason why many central banks in Japan and the West continue to expand their quantitative easing programs:

"They have decided that if it doesn't work, we will continue to increase our efforts until it does."

The costs of these policies have only now been reflected in the form of IOER, as inflation has taken center stage and central banks have been forced to tighten their policies.