Every Possible Quantitative Tightening Outcome.
What happens when you start burning money?
A summary of this letter:
What happens when the Fed, the US Central Bank, starts Quantitative Tightening a.k.a. legal money burning?
Path #1: The Fed engineers a soft-landing.
Path #2: Like the last time, money printing makes a comeback.
Path #3: QT bursts the asset bubble, but doesn’t do much to fight everyday rising prices.
Path #4: QT is inflationary instead of being disinflationary/deflationary.
I've tried to minimize opinion in this piece. (Apart from the below. Couldn’t help it.)
Let’s dive in!
Dear all,
Do you ever get tired of authors passionately advocating for their world-views? Well, I do, and sometimes I wish for merely a simple list on what to expect in the future; An occasional break for the reader from all that passion and emotion.
In that spirit, here’s a list of what Quantitative Tightening (QT) — the legal burning of money of sorts — may lead us to. A comprehensive summary of every possibility.
I don’t know if McKenna is right about Ukraine receiving excessive coverage, but he’s spot on about QT receiving insufficient attention. This trend is starting to reverse though, with big names coming out about QT e.g. Paul Krugman, Alfonso Peccatiello, and the Bitcoin Magazine, as May comes closer.
In the midst of this all, perhaps it’d be nice to hear what a small name (me, yes, I exist) has to say about QT. If you’re well-read up on QT and its history, feel free to skip to the later sections.
A Primer on QT:
What’s QT, really?
The short answer: the burning of money. Not literally, but it’s like deleting money out of existence by pressing a key.
The longer answer: the opposite of Quantitative Easing. There are two key happenings here: 1) The Fed lets the assets it holds mature and does not reacquire more assets and 2) it becomes a persistent seller. The result: less cash and more assets moving around in the economy.
A more nuanced view: technically, QT is unlikely to entail an actual drop in the quantity of circulating money, since banks create new money every time they make a loan. It’s more likely to reduce the rate of growth of net circulating money. If the rate of growth of the circulating money supply slows down, and the rate of growth of actual economic production speeds up, inflation will decrease.
The longest answer: check out the Fed guy if you want to get technical and precise. (Or hit me up on Twitter — I’m always up for this kind of conversation.)
Why QT, and why now?
Wherever you stand on the political spectrum, one thing we can all agree on is that the US economy is overheated. We may differ on the biggest cause: Republicans usually lean towards “too much money”, whereas Democrats generally blame “Supply-chain disruptions”. But there’s more in common between those two statements than many may realize, for the essence is still the same:
Too much money chasing too few goods.
It’s also worth noting that QT isn’t the only policy being used. Interest rate hikes are going to happen simultaneously. Ultimately, the Fed’s message is clear: the economy is overheating, and we’re serious about curbing inflation.
The pathways that QT can lead us to:
Path #1: The Fed manages to successfully engineer a soft-landing.
If Jerome Powell can pull this off, I’d put him right up there with Paul Volker.
There are some risks once the Fed starts setting cash on fire. For starters, a stock market propped up by money printing might go into a free fall. Or highly leveraged financial institutions will face higher interest rates on their debt, leading to them having less cash to loan out. And so on.
For example: if Citigroup finds that it’s unable to get cash quickly to repay its loan coming due, its investors and customers will panic. A broader loss of faith in the banking system will occur. People will start withdrawing their money, people will stop spending, and the economy will collapse.
Conversely, if the Fed’s burns money at just the right pace, effects may be minimal and circumvent broader market concerns. But it’s no easy task. As we’ll see under Path #2 below, it’s practically never been done.
Path #2: QE makes an eventual comeback.
Below is a summary of what happened the last time the Fed did QT.
Oct 2017 to Dec 2017: QT begins gradually; Fed starts burning $10B per month.
Jan 2018 to Sep 2018: QT picks up pace; Fed starts burning $30B per month.
Oct 2018 to Dec 2018: QT really gets going; Fed starts burning $50B per month.
Jan 2019: the famous pivot; Fed creates $60B, and truly restarts the money printer.
So at peak fire, $60B was being burnt every month. This time round, the Fed’s going to be starting at $95B.
To be fair, the circumstances today are quite different: inflation is higher and the Fed’s balance sheet is much larger. But the base concern is the same: confidence is fragile. If one financial institution finds it hard to get liquid cash and raises the rates at which it lends, others may follow suit, and suddenly, it’s much harder to even get a loan.
(If you’re interested, here’s a deeper dive on what exactly Alf means.)
Sure, that’ll achieve the intended disinflation (or even deflation), but at the cost of a painful recession. The US economy is driven by debt-driven spending, and that reality makes this path even more concerning.
Once stuff goes bust, the government will turn the money printer back on. A pivot may even occur earlier if the Stock Market starts getting hurt badly, owing to pressure from political lobbies.
Path #3: QT bursts the asset bubble, but doesn’t do much to fight increasing everyday prices.
There’s no doubt that quantitative easing has fuelled an asset bubble, from home prices to stocks. However, there’s a huge debate on whether QE has led to an increase in the prices of everyday goods and services.
If we take a Democrat’s perspective and blame most of it on supply chains and corporate power, QT won’t reverse inflation, because QE wasn’t originally to blame.
However, we’d then have 1) a stock market crash and 2) no change in inflation. A terrible combination. This would likely lead us back to Path #2 — where the Fed is pressured into re-engaging in QE.
Path #4: QT causes demand-driven inflation.
This one’s an oddball. Obviously, the intent of QT is to curb inflation, not boost it. But stick with me.
(for beginners who might be reading)
Money Velocity = How fast money moves from person to person
Recall that QT’s aim is to reduce money supply growth. Interestingly, pre-Covid, changes in money supply were inversely related to changes in money velocity. And during much of this same period, the US experienced increasing inflation.
One hypothesis was that somehow, burning money came with whatever money was left moving around faster. Burning money is disinflationary/deflationary, but increased money velocity is inflationary. The theory goes that QT was inflationary in practice because that latter effect prevailed.
13D Research was the first to point this out back in mid 2017, and here’s a recap of this scenario:
Burning money → Money moving around faster → Net inflationary effect (in actuality)
Burning money → no significant change in money velocity → net deflationary effect (in theory)
But why would burning money cause what’s left to move around faster?
Here’s my best guess.
QT occurs in a time when there’s growing general confidence in the economy → Money velocity increases as people spend more → Inflationary effect
i.e. Burning money is correlation, not causation. Let me know if you have any other theories on this below, or if you disagree.
The vexing reality of QT (and Economics):
That it’s practically impossible to agree on anything and know for sure. For example, if the Fed’s actually doing a good job but people get irrationally scared by the $95B number, stuff goes boom. If the Fed’s doing a bad job but nobody realizes, stuff goes quite alright.
Regardless, let’s stay optimistic. @MacroAlf said that QT isn’t the end of the world, and I’ll go one step further and say that nothing is.
I’ve intentionally kept my personal opinions on where I see QT going out of this piece. I’d love to know which path you think we’re headed toward and whether there are any pathways I’ve missed.
I’ll be back next week with my thoughts on where QT will lead us. Here’s a hint for now, though:
Till next time,
Ja ne!
P.S. I created this newsletter to share, get roasted, and learn along the way. So if there’s anything you feel that I got wrong, or you’ve feedback in general, do let me know in the comments or DM me on Twitter!
Image References:
https://www.pinterest.com/pin/631137335270766893/
It’d be good to add your take on where this goes, my money is on path#2