What is the impact of the Fed response to high inflation on the domestic and international economies, and how have other central banks reacted?
- Inflation in the U.S. is still running hot, peaking in June and only slightly receding by September.
- The Fed’s response of raising interest rates may be limited by a continuation of tightness in the labour market.
- The strength of the U.S. dollar has caused many central banks to shadow the Fed’s interest rate rises to combat inflation.
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U.S. Y/Y CPI inflation peaked in June at 9.1 percent, the highest level since hitting 14.5 percent exactly 42 years earlier.
The pace has since moderated with September Y/Y inflation dropping to 8.2 percent, but this is still uncomfortably high and there are indications that a persistent source of inflation is emerging.
Figure 1 shows the annualised change in unit-labour costs (ULC) as a four-quarter average to better indicate the trend. In the chart, the deflationary pressures following the 2008 financial crisis are evident in shrinking labour costs in subsequent years.
The deflationary conditions are also reflected in the real (adjusted by trailing Y/Y CPI inflation) Fed funds rate going into negative territory, also shown in Figure 1. ULC inflation started trending higher in the first quarter of 2019 but the pattern turned erratic with the onset of COVID-19 and it briefly went back into negative territory in the middle of last year.
More recently, the widely reported tightness in U.S. labour markets propelled wages and ULC sharply higher. The moving-average annual rate hit 7.8 percent in the second quarter and the annualized Q/Q rate is a much higher 10.8 percent.
When CPI inflation initially surged in the early months of 2021 it was widely assumed – including by the Fed – that this largely reflected COVID-19 related supply-chain disruptions and would fade with time.
A year later, it became increasingly apparent that rising inflation was not just supply-chain related, prompting the Fed to begin raising the nominal Fed funds rate. (ULC started trending higher in early 2019, suggesting capacity constraints were emerging ahead of COVID-19.)
The Fed responded to the growing evidence of underlying inflation in the economy by starting a steady series of Fed funds rate hikes in March from near zero to just over 2 percent. The futures markets are pricing for the Fed hike rates to about 4.5 percent in the middle of next year, with the trend reversing to lower rates by the first half of 2024.
Figure 1: U.S. unit labour cost inflation and the Real Fed Funds Rate
Figure 1 suggests the market outlook on rate hikes may be too conservative.
Fed funds in real terms are deeply negative at around -8.5 percent, so unless inflation diminishes very quickly, real rates will still be in negative territory (i.e., monetary conditions will still not be “tight”) in mid-2023 when the market is priced for nominal rates to peak.
Figure 2 suggests that ULC gains are likely to remain strong unless the labour market goes into an immediate downturn. While not tight, there is an apparent long-term relationship with the trend in non-farm payrolls leading ULC inflation.
The history of the series suggests it will require the trend in monthly payrolls to drop below 200,000 to get ULC inflation back toward the Fed’s annual 2 percent target rate.
Figure 2: Federal Reserve balance sheet holdings and Real Fed Funds Rate
The impact of QE
As Fed funds headed toward zero in the wake of the financial crisis, the Fed adopted the, then radical, concept of quantitative ease – e.g., buying long-term instruments to reduce long-term rates and inject additional liquidity into the money markets.
As is shown in Figure 3, the purchase of these long-term assets ballooned the asset side of the Fed’s balance sheet. It is widely anticipated that tighter monetary conditions will be reflected in a reversal of the balance sheet surge.
Indeed, when the Fed started raising Fed funds in 2019 in response to early signs of firming inflation, its asset holdings started drifting lower (note the scale for the balance sheet is inverted) and there are signs that the recent move to higher Fed funds is also seeing a drawdown in the balance sheet.
The balance sheet data is released later than CPI, and the current drawdown is probably bigger than shown in the chart.
Just as the Fed steadily increased the balance sheet when Fed funds based near zero, the Fed is likely to let the balance sheet run down (at a minimum by not replacing maturing securities) well after the Fed funds rate has reached its target level, particularly if it intends to reverse the post-COVID-19 injection of liquidity.
The bottom line is the balance sheet is likely to keep shrinking at least into the second half of next year, even if Fed funds did peak in the first half of the year.
Figure 3: Federal Reserve balance sheet holdings and Real Fed Funds Rate
Fed tightening does not stop at the U.S. border
The dollar’s role as the primary global currency means that much global trade – especially, commodities – is priced in dollars, even when the United States is not involved in the trade, and it is also cleared and financed in dollars.
Moreover, the emerging market world is heavily dependent on dollar borrowing as a basis for funding current account deficits. The implication is that when the Fed hikes the Fed funds rate and reduces liquidity through balance sheet reduction, it has a direct impact on global financial conditions and economic activity.
Figure 4 again shows the Fed’s balance sheet (this time not inverted) and the Bank of International Settlements (BIS) reported net USD-denominated offshore-bank claims on non-bank borrowers.
Although the lags and leads are idiosyncratic, there is a broad relationship between the extension of Fed liquidity via expanding the balance sheet and net off-shore USD-related net bank lending.
It is notable that despite the post-COVID-19 balance sheet expansion off-shore net lending has stagnated; there is a clear risk that sustained balance sheet contraction will be echoed in tighter lending conditions in global markets.
Figure 4: Fed Funds balance sheet and BIS reported net USD bank claims on non-banks
In principle, international banks could substitute USD financing with other currencies, but Figure 5 suggests this is highly unlikely. While non-USD net claims are roughly the same size as USD net claims, total net claims move in lockstep with USD funding.
Central banks in most developed markets – Bank of Japan is the one clear exception – also face pressure to tighten money supply in the face of rising inflation, so it seems implausible that lending conditions will significantly diverge in the dollar and non-dollar credit markets.
Global liquidity is almost certainly headed for an extended period of contraction.
Figure 5: BIS reported total net bank claims and USD bank claims on non-banks
Shrinking dollar liquidity
As shown in Figure 6, the dollar surging to multi-decade highs against an array of currencies is a manifestation of the impact of the global shrinkage in dollar liquidity.
The likely mechanism is that the dollar dominates the global borrowing market. Tighter conditions and higher rates are forcing borrowers to reduce their exposure, which requires purchasing dollars with local currency.
The stronger dollar creates inflationary pressure in other countries – especially via dollar-denominated commodity prices – so foreign central banks have the stark choice of accepting higher inflation or shadowing the Fed’s rate hikes.
Most central banks are going the latter route amplifying the impact of Fed tightening in the global financial markets.
Figure 6: Net bank claims and the broad nominal dollar index
Where does the buck stop?
For the developed countries, net dollar financing is small relative to local-currency flows. Nevertheless, the Fed’s leadership in rate hikes and the global scramble to drawdown dollar debt has led to a surge in the dollar’s value against other developed country currencies.
The strong dollar is adding to local inflationary pressures, so most developed country central banks are following the Fed’s lead and raising local rates. Dollar funding is a much more important source of net funding for many emerging markets, augmenting the impact of the Fed.
Figure 7 shows selected emerging markets that potentially have the biggest exposure to shrinking global finance. The blue bar is the ratio of net BIS claims on that country versus international reserves and the orange bar is the dollar gain or loss against the currency over the past year.
Brazil and Mexico are the two outliers as the MXN and BRL are rare currencies that have gained on the USD over the past year.
It is not a coincidence that these countries are also among the very few that have positive real interest rates. But going forward, either currency could become very vulnerable if their central banks do not maintain this relatively strong commitment to high real rates.
Generally, lower reserve coverage of net claims is associated with weaker exchange rates.
The currencies of Indonesia, Vietnam and Chile stand out as having weakened more modestly than would be indicated by the degree of foreign exposure and none of them have positive real interest rates.
The Chilean peso looks particularly at risk as the other two countries have the benefit of a current account recently moving into surplus.
As in the developed world, weak currencies are adding to inflationary pressures and emerging market central banks are also responding with higher rates.
Figure 7: Total net bank claims vs international reserves and currency performance
The dollar’s central role in global trade and finance is serving as a conduit to export the Fed’s commitment to tighten and hike rates across borders to almost every open market.
However, as was discussed in last November’s Market Voice, and is shown in the chart below, many emerging market central banks were ahead of the Fed on hiking rates.
Given their high inflation history, they lacked the Fed’s credibility and were forced to respond more quickly to signs of local inflation – even if they believed it was supply-chain related.
Despite this early move to tightening, more recent hikes by the Fed, as discussed, are broadly strengthening the dollar maintaining the pressure on emerging market banks to tighten – this is even true for Brazil and Mexico, where rate hikes in the past year have exceeded the Fed.