Private Sector Risk Taking Will be key as the Fed starts to taper

Last week the US Federal Reserve lifted short term rates by another quarter point, meeting analysts’ expectations. However, the Fed also surprised by announcing its plans for paring back the size of its balance sheet during the second half of this year; something analysts had not been expected for some time.

Despite weak inflation figures, the Fed pressed ahead with its decision to increase rates, and policymakers remain set on plans to increase rates further in the coming years, including another quarter-point increase by the end of 2017.

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Along with this bullish rate forecast, Fed policymakers updated a previous document setting out their principles and plans for normalizing the balance sheet last week. While Janet Yellen declined to say when the central bank would begin to action this plan, the extra color offered within the Fed’s update will allay some concerns analysts have expressed about the Fed’s lack of planning when it comes to balance sheet normalization.

According to the plans, the Federal Open Market Committee will reduce reinvestment of principal payments received on maturing securities in its portfolio. Payments will only be reinvested to the extent they exceed a set of gradually rising caps. The FOMC anticipates that the first cap will start at $6 billion per month and increase at a rate of $6 billion on three-month intervals over 12 months until it reaches $30 billion a month. For mortgage-backed securities, caps will start at $4 billion per month and increase in steps of $4 billion at three-month intervals for 12 months until they reach $20 billion per month.

The fact that the Fed is planning to initiate this balance sheet normalization in the near future surprised some analysts because the more bearish economists still believe that the global economy cannot yet stand on its own two feet without central bank support.

Economists at investment bank Morgan Stanley ponder this topic in a research note sent to clients last week. The bank’s analysts draw the conclusion that while some economists believe the global economy cannot withstand monetary policy normalization, the impact on growth will be entirely dependent on private sector demand and fiscal support.

Private sector risk taking will help the Federal Reserve

Morgan’s analysts point out that since the financial crisis there have been two occasions where the markets have panicked anticipating a sudden Fed pull back from markets. The end of QE2in 2011 and the taper tantrum episode of 2013 are instructive because during both occasions markets clearly weren’t prepared for such a move:

“When the Fed ended QE2in 2011 and its balance sheet contracted as a percentage of GDP somewhat from the end of 2011 to 3Q12, the private sector was still in deleveraging mode. In 2013, the Fed's announcement to taper QE triggered an adverse market reaction, with DM financial conditions tightening, as investors had not been prepared for such a move. Moreover, fiscal policy support was reduced simultaneously and large parts of EMs were externally exposed, which, when faced with the prospect of higher US real rates, triggered the EM adjustment phase. In addition, US private sector risk taking attitudes had not fully normalized.”

Morgan: Private Sector Risk Taking Should Help Fed Taper

Today, however, the markets look better prepared. For example, private sector risk taking appear to be normalizing with clear evidence of a pickup in private sector demand over the past 12 months. Additionally, until 2015 fiscal policy had been on a tightening path but since last year fiscal policy has been moderately expansionary. These two trends should ensure that economic activity continues to expand even as central banks rein in monetary policy:

“Against this background of normalizing private sector risk attitudes and still supportive fiscal policy, central banks are removing policy support in a counter-cyclical fashion. Notably, DM financial conditions have stayed supportive as well. Indeed, with the economies transitioning towards self-sustaining growth, we expect G3growth to improve to 2.0%Y in 2017 from 1.6%Y in 2016 and remain healthy at 1.8%Y in 2018.”