Mike Dolan

LONDON, (Reuters) – If central banks begin to drain the money pool in an effort to stem skyrocketing inflation, then the world market will need to know how much liquidity there is.

The U.S. Federal Reserve’s hawkish New Year’s blitz has sent markets scrambling for as many U.S. rate increases as possible this year, despite near full employment and inflation readings of 7%.

More pressing are Fed signals from the Fed that it’s time to siphon some of its emergency bond buy money into the financial system – money intended to keep the economy afloat during this shocking pandemic lockdown.

Surprised investors! The Fed’s December policy meeting began discussions on shrinking $8.7 trillion of its balance sheet. In addition, it decided to end all new bond purchases in the first three quarters of 2022.

Although it seems strange that Fed officials are pressing for a reduction in its balance sheets, despite plans to continue adding to them until March 31, many Fed officials this year insist that such a process should be underway soon. What time and what speed?

Raphael Bostic, chief of Atlanta Fed was very explicit in a Reuters interview this week.

Bostic thought that the Fed’s runoff should be initiated shortly after the March interest rate hike.

However, he said that the so-called “quantitative loosening” (QT) should forcefully be at $100 Billion per month. That’s twice the pace of 2017-2019’s balance sheet decrease. He also identified $1.5 Trillion of pure excess liquidity, which needed to be removed before we can assess the effect at that point.

Bostic didn’t specify where the $1.5 trillion was taken from. However, it is roughly the same amount as what the Fed had to take from the money market every day over the past few weeks through overnight’reverse repos’ operations.

Loretta Mester, chief of Cleveland Fed, was a voting member this year of Fed’s Open Market Committee. She told Wall Street Journal that she believes the Fed should reduce the Fed balance sheet as quickly as possible to avoid disrupting the markets. However, she said that active sales of assets should be an option for the Fed.

The Fed seems to be serious and the market numbers crunchers are working overtime.

EXCESSION AND VELOCITY

Nikolaos Panigirtzoglou, JPMorgan’s liquidity specialist Nikolaos Panigirtzoglou, and his team concluded that we have passed the point of no return for what they call global excess money supply. Their proxies to broad liquidity will also shrink over the next two-years.

JPM now expects Fed QT to begin in July, following the second rise. Assuming it has reached a $100B monthly rate of Treasury and Agency bonds, the market will need additional $250B in debt from the government or agency borrowers by the end this year. This would mean that the market needs to absorb about $1Tillion of new debt in 2023 and $350B in 2022.

It now believes that the net global bond demand is declining by $1.3 trillion, based on its current measure. JPM also believes that historical correlations will show that yields on global bonds aggregate indices should rise an average of 35 basis points.

The Fed QT’s liquidity impact is also felt by commercial banks, who have less reserve funds at the Fed than they do with their own lending capacities. Although this global effect will be mitigated by the Bank of Japan and European Central Bank bond purchases this year, JPM believes it will become more severe in 2023 when central banks stop buying new bonds.

A drop in central banks’ bond buying and slower global loan demand after pandemics have caused their estimates of global money supply growth to more than halve from $7.5 trillion to $3 trillion last year. They also expect to see an increase in annual money growth of around 5% in 2023.

Is this going to reduce estimates of the ‘excess? JPM believes that the excess has already been eliminated when JPM examines global proxy measures for “excess” measuring the world’s money growth relative to nominal GDP, or the proportion of cash as a percentage of household equity or bond holdings.

Are all these things under control now? This will be sufficient to stop inflation from running amok in the markets.

Pascal Blanque is Amundi’s Chief Investment Officer. He believes there will be a new inflationary regime similar to that of the 1970s. The reason for this change is because central banks will have greater money control and will borrow more from governments. With post-COVID reconstruction, climate change and fiscal expansion, it will not matter if they are able to expand their financial resources.

“In this new system, the governments will assume control over money and maintain widespread, double-digit monetary expansion for many years as part of a larger transition from free markets forces, independent central bank and rule-based policy to a command-oriented economy.”

Blanque believes that the main reason inflation did not rise over the last decade is because of a drop in velocity (or the rate at which one Dollar is used in transactions) in real economic. This was purely transferred to financial assets.

If you consider real and inflation as one, velocity might have been as stable than monetary theories suppose. He wrote that ongoing money pumping would eventually prove inflationary – even if it is for coincidentally low asset and consumer prices.

The editor-at-large of finance and markets for Reuters News is the author. These views are solely his.

(by Mike Dolan. Twitter (NYSE:).: @reutersMikeD. Editing by Mark Potter