Fighting global inflation, now at its highest point in decades, has become a number one priority for major central banks around the world. Monetary policy measures that include raising rates are not yet having the desired effect – but it will take time. Nevertheless, there are serious concerns that even such all-powerful institutions as the U.S. Federal Reserve are “running out of ammunition,” and there are fewer and fewer opportunities to influence the situation. The problem is that to support monetary policy the Fed needs to liquidate a giant overhang of U.S. government and mortgage bonds totaling $9 trillion. It was not so easy to do this: there is not enough liquidity to successfully reset even part of these securities.
The situation has already been dubbed “the Fed’s worst nightmare”. What does this situation mean for the U.S. and global financial system? That is what we will talk about today.
What Does QE Have To Do With All That?
As we all remember, in 2008, the global financial crisis struck. Traditional measures to influence the financial sector, which was literally falling apart before our eyes, i.e. lowering the refinancing rate, were no longer working. It was decided to apply the “experimental treatment” – buying up bonds to fill the market with liquidity and provide access for banks, and then all economic players on the chain to cheap financing. The U.S. Federal Reserve was a pioneer in this endeavor (although the experience of the Bank of Japan, which applied similar measures in the 1990s, was partially used). The strategy was called “quantitative easing” (QE).
Until the end of the decade before last, the Fed’s balance sheet was quite small. Bonds were bought all the time, but it was a systematic buildup, more or less correlated with the growth of nominal GDP. From 2004 to 2008, for example, the total amount of securities under the system’s control increased from $750 billion to $900 billion. In essence, these purchases were a technical measure.
Since September 2008, when QE began, the balance sheet began to swell in an avalanche fashion. In a little over a month, the Fed bought more bonds in the market than it had in the entire previous period combined. By December the volumes exceeded $2 trillion. Initially, it was believed that the plan was purely temporary and the Fed would restore the pre-crisis status quo at the first opportunity. But this did not happen: a couple of attempts to reduce the balance were unsuccessful and then they stopped taking risks. By the mid-twenties, the volume of QE-bought bonds had stabilized around $4-5 trillion, and after U.S. economic growth resumed, they began to think about gradually reducing these “reserves”. By the fall of 2019, they had indeed fallen to $3.8 trillion. But then the pandemic happened, and in a matter of months, the balance doubled again, this time coming close to the $9 trillion mark (over 40% of the US GDP).
Only the acceleration of inflation to 40-year highs raised the question. The Fed began to aggressively raise the rate to somehow restrain the accelerated prices. But at the same time, it was necessary to ensure a “thinning” of the balance sheet. This process was called “quantitative tightening” (QT) – the opposite of QE. The idea here is that when bonds sell off, supply begins to outweigh demand, and the rates on the securities rise. As a result, they begin to increase throughout the economy. Companies and consumers, faced with higher rates, are less willing to get into debt, after which money turnover shrinks and the economy cools.
Technically it looked like this: the Fed was selling the bonds they had on their books or, alternatively, waiting for them to mature. From a financial market point of view, there is little difference between these actions. At this rate, in about a year, the balance sheet would have shrunk by about a trillion dollars.
Here U.S. central bankers faced consequences no one could have predicted – it turned out that there wasn’t much liquidity in the market to easily “digest” the securities being dumped. The first bell of this type rang in 2020, at the very beginning of the pandemic. Then the market actually “broke,” and investors began to sell off bonds en masse, getting to cash. The Fed had to step in, demonstrating its status as a “buyer of last resort”. The situation now is similar, albeit (for now) not as acute. The depth of the market is at one of its lowest levels ever, while the volume of bonds in circulation has risen about fivefold over the past 20 years. All of this leads to unprecedented volatility in the world’s calmest and most stable financial market segment. This volatility, in turn, further reduces liquidity, creating a vicious circle.
The decline in liquidity is particularly evident in older bonds, which make up the majority of securities in circulation, but only about 25 percent of the daily trading volume. As a rule, new issuances are already selling at a premium to older ones, but in times of market turmoil, this premium can increase markedly. It is now at its highest since 2015.
Was There Any Chance To Avoid Such High Inflation?
These levels of inflation were avoidable. If we trace the chronology of the rise in inflation, the 2% level, which is usually targeted by the Fed, was exceeded back in March 2021. Then in April the inflation rate was already above 4% and has not fallen below that level since then. However, this clearly did not bother the Fed, which at that time interpreted the growth of inflation as a “temporary phenomenon” and did not take any active measures. Only in November 2021, the reduction of asset purchases began, but the program still continued until March of this year.
The Fed was also in no hurry to raise the rate. Thus, it was obviously late with its actions and could not slow down the growth of inflation in advance. That’s to slow it down, not stop it. The problem is that the Fed does not have effective tools to deal with cost inflation in the short term. The tools that do exist affect cost inflation indirectly, not directly, as in the case of money supply inflation.
Reducing current inflation is both easy and difficult. It is necessary to slow down the growth of costs. This can be achieved, in particular, by reducing commodity prices, which are set based on the supply-demand ratio, but it is impossible to sharply increase the volume of supply in the current environment – it is impossible for many commodities. Accordingly, the only possible option is to reduce demand. Thus, during the pandemic, a demand reduction prevented inflation from accelerating. Now, strange as it may seem, the growth of inflation itself may contribute to a reduction in demand.
For developed countries, inflation close to 2% is considered normal and does not interfere with a healthy economy. Although wages often rise with inflation, the amplitude of these two indicators does not change by the same amount. Often wages grow less and with a large time lag. It follows that when income remains at the same level and prices for goods and services rise, citizens begin to consume less, refusing goods and services of the second necessity. The situation worsens if the labor market begins to weaken – an increase in unemployment further reduces aggregate income.
So far the U.S. labor market is stable, but there are already hiring freezes and layoffs in some companies. Businesses are preparing for a worsening economy and are cutting costs to maintain margins. Note that consumption is so important to the U.S. economy because consumer spending accounts for about 2/3 of the country’s GDP. As a consequence, this leads to a slowdown in GDP growth and subsequently to a decline in GDP. Then, as prices fall and wages rise, demand begins to recover, as does the economy as a whole. Consequently, for economic growth to continue, the economy needs to slow down. Hence the cyclicality of the economy that is written about in economic theory textbooks.
Although higher rates do not immediately affect the rate of inflation, over time they do. The impact comes through the availability of credit. Higher credit costs lead to lower demand for credit, which in turn leads to a weaker overall demand for goods and services.
Also, tighter monetary policy leads to pressure on the stock market, which reduces investor wealth. When you reduce your investments, the so-called wealth effect kicks in – and you start to spend less. In previous years, this effect worked the other way. As the investment portfolio grew because of the rise in the U.S. stock market, people were spending more and saving less. This is borne out by the relatively low savings rate. Now it will work in the opposite direction and gradually contribute to lower consumption as well.
How Can You Benefit During High Inflation?
Even in the face of tighter monetary policy, there are resilient sectors. The health sector is one of them. If consumption declines, the population will reject non-essential goods in the first place, but not life-saving medicines, so historically this sector has shown relatively positive dynamics in times of high inflation and economic slowdown. However, companies with positive cash flow and already approved drugs should be favored in the sector. Also, an additional driver for the sector could be an increase in mergers and acquisitions.
Nevertheless, the risks of investing in biotech companies are quite high, so diversification should not be forgotten. The above-mentioned sector is not the only one that looks attractive at the moment. But in times of uncertainty, it is better to favor investing in individual companies over investing in a broad market index. In general, it is wise to choose players with positive cash flow, low debt burden, and business stability in the current environment.
