Future Liquidity Depends on Credit Creation
The authors are economists of Shinhan Investment Corp. They can be reached at hwanyeol.kim@shinhan.com. – Ed.
Reasons behind Fed’s earlier-than-expected quantitative tightening
Discussions of quantitative tightening have commenced among US Federal Reserve members, as indicated by the minutes of the December 2021 FOMC meeting. This has raised volatility in the financial market. The Fed is now likely to start quantitative tightening in 2H22, earlier than the previously projected 2024. Earlier tightening vs. past episodes of monetary policy normalization is attributable to the difference in how liquidity was created. The current excess liquidity was generated through a combination of the government’s fiscal expansion and the Fed’s quantitative easing, and thus can be controlled more effectively by quantitative tightening rather than rate hikes.
Outlook on the pace of quantitative tightening and rate hikes
We expect the Fed to start quantitative tightening within three to six months after its first rate hike in 2022, based on the FOMC minutes. Assuming the first rate hike in March, tightening should begin in June at the earliest. The Fed is forecast to absorb mid-USD1tr levels in excess liquidity over a period of about 21 months by reducing its balance sheet at a pace of USD80bn per month. We believe the Fed will slow the pace of rate hikes during quantitative tightening as: 1) inflation will stabilize via liquidity control; and 2) low-rate policy stance needs to be maintained to support fiscal spending.
With withdrawal of excess liquidity, future liquidity depends on credit creation
The excess liquidity, which has driven an overall boom in asset prices, will be absorbed through quantitative tightening. While the absolute level of liquidity will remain the same until 1H22 prior to the tightening projected in 2H22, we expect to see style rotation with changes in risk premiums. Liquidity conditions from 2H22 should hinge on credit creation. If credit is created in large quantities along with growing investments, market liquidity should increase despite reduction or stagnation in M1 money supply caused by quantitative tightening.