The Fed’s long walk to normalisation might have to turn into a jog

published 21 September 2017

170921-fed-b — The Fed has decided it's finally time to start winding down its post-QE balance sheet

Whatever else the world's central banks are responsible for, someone needs to take them to task for their crimes against the English language.

First, we had quantitive easing,then, we had the "taper",now it's time for "balance sheet normalisation".

If you managed to stay awake during the course of that last sentence I'll now explain to you what it is and whether it matters or not...

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The amazing expanding balance sheet

As expected, the US central bank didn't do anything to interest rates. They stayed at 1%-1.25%. However and also as expected the Fed did decide that it's finally time to start winding down its post-quantitative easing (QE) balance sheet. That'll start from next month.

Now, let's have a quick recap on what this actually means. When the Fed does QE, it prints money (electronically of course), and uses it to buy government bonds (or whatever else it wants but let's stick with the bonds).

When the Fed buys stuff, its balance sheet gets bigger. Currently, it's got about $4.3trn-worth of stuff sitting on it.

Now, the Fed stopped doing actual QE in 2014 (that was the "taper"). It stopped printing money to buy stuff. However, it didn't shrink its balance sheet.

You see, when you own a bond, it eventually matures and repays you the original loan (a bond is just an IOU). It pays you interest on the way as well. For now, when a bond the Fed owns has matured, or paid it interest, the Fed has just used that money to go out and buy more bonds. Therefore, its balance sheet stays roughly stable.

From next month, the Fed will start shrinking its balance sheet. It will start by allowing $10bn to "run off" each month. Every quarter, this'll rise by a further $10bn a month, until it reaches $50bn a month.

At that rate, as Capital Economics points out, it'll take a hell of a long time to get the balance sheet anywhere close to pre-2008 levels (well below $1trn). Indeed, at that pace, four years from now, the Fed could still be sitting on a $3trn balance sheet.

So it's not exactly a crash diet.

In any case, the market took all this in its stride. It was all expected. The only really mild surprise was this: the Fed seems to think it might raise interest rates again this year.

The market is used to the Fed being a bit more dovish than anyone expects, so this mild hawkishness saw the dollar perk up (it's been way down in the doldrums recently), and it managed a bit of a rally against most other currencies.

Of course, that gave gold a bloody nose too (gold and the dollar tend to move in the opposite direction to one another it doesn't happen all the time but it does happen a lot).

How far behind the curve will central banks remain?

Well, to my mind, there's only one really important question right now: when will inflation take off?

Right now, everyone's baffled by its absence. But as I mentioned earlier this week, we've been here before. In the early 1960s, inflation was dead. By the mid-1970s, it was in double digit territory.

We've worked ourselves into this corner where we ponder and stroke our chins and ask: "Why has this recession been so bad? Why aren't we recovering? What's wrong with our system? What's wrong with us?!"

But the answer is pretty clear. Reinhart and Rogoff literally wrote the book on it ages ago. "Recessions surrounding financial crises are unusually long compared to normal recessions." This is just what happens after your banking system blows up. It takes time to recover.

The thing is, we're pretty much at the turning point now. Labour markets across the globe are tightening, and I don't care how many robots are coming over here and taking our jobs and eyeing up our prospective life partners they're not going to do it quickly enough to keep wages from rising.

There is no "new normal". There is no "secular stagnation". This is bog-standard boom and bust, stretched out because the boom was so big and the corresponding bust so great as a result.

The next phase is reflation, when all the things that people have given up on ever happening again like rising wages and rising consumer prices start to happen.

The question then is: how far behind the curve will the world's central banks remain? I think the answer to that is: as far as they can get away with. Which means that inflation will be a good bit higher than anyone expects (and "real" interest rates a good bit lower).

That in turn is good for stocks (at first); probably very good for commodities (fears over China are denting these for the time being, and certainly a deflationary bust over there is not out of the question); bad news for bonds; good for gold; good-ish for property (but the debt financing side makes this trickier); and mixed for cash (it depends on just how far behind the curve central banks remain).

It's time to pay very close attention to the inflation statistics. Once it starts to take off, I don't think it'll take long for investors' mindset to flip.

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.