MNI INTERVIEW:Fed Would Pause QT, Not Hikes, On Market Turmoil

Market instability will not dissuade the Fed from pressing on with its aggressive interest rate hike campaign, but the central bank is likely to to pause its balance sheet runoff sooner than it has signalled as financial volatility heightens systemic risks, former White House economist Joseph LaVorgna told MNI.

“I don’t see the Fed going anywhere near as far as what they expect on the balance sheet and look for them to certainly stop that if not this year, next year,” LaVorgna, former head of the White House National Economic Council under President Trump, told MNI’s FedSpeak podcast.

“A mini-pivot might mean the Fed opening up swap lines with other central banks as they’ve done before, and then possibly temporarily stopping QT until market conditions stabilize.”

The process of unwinding the USD8.8 trillion is problematic in an environment where financial instability is mounting and Treasury market liquidity has been weak, LaVorgna said. (See MNI INTERVIEW: Fed's QT Could Trigger Liquidity Crunch-Rajan)

“We haven’t had an issue yet in the sense that there hasn’t been a lot of Treasury supply maturing since they doubled the pace of the maturation,” he said. “But come November, with that being a refunding month, the supply will be larger and conceivably that could pose issues for markets going into year-end on what’s already been a difficult year when liquidity tends to be poor anyway.”

NOT A MILD RECESSION

While financial stability concerns will be a determining factor in its balance sheet operations, it will be a rapidly slowing economy that is likely to convince the Fed by early next year that it’s time to pause rate hikes in order to assess the lagged effects of policy on output, which is already showing signs of weakness, said LaVorgna, chief economist at SMBC Nikko Securities.

“That scenario would happen if the economy is substantially weakening, where the unemployment was clearly on its way to 5%, into the fives and maybe higher so that the Fed knew a recession was guaranteed,” LaVorgna said.

“At that point the Fed would have the confidence that inflation, even if it was high relative to target, would come down quite dramatically,” and would even entertain interest rate cuts despite official reassurances to the contrary, he said.

LaVorgna sees that juncture arriving sooner rather than later and doesn’t believe the fed funds rate will get “meaningfully” above 4%. Even so, he thinks we could be headed for a fairly painful recession.

“I would push back against it being mild, simply because the Fed seems hellbent on destroying demand and monetary policy is a blunt instrument and they don’t know how far they have to go to kill inflation and when inflation does start to move down it’s likely because they went too far,” he said.

UK WARNING SIGNS

LaVorgna said the troubles in the UK’s pension system are not localized because they reflect leverage and reach-for-yield behavior that is the product of years of super low interest rates.

“It’s a remnant of excessively loose policy for a long time and our decision globally to try to remove that accommodation is going to cause all sorts of cracks in the system,” he said. “We’re going to see how robust it is. I do worry there will be some other shoe to drop somewhere.”

LaVorgna said it’s much harder to tighten policy this aggressively now than in the past because of high debt-to-GDP ratios in the U.S. and around the world.

“That attempt to remove and normalize policy can cause a whole host of problems,” he said. “We’ve seen a lot of stress so far in the front end. Stress in Libor OIS is a sign that if not a dollar shortage, certainly dollar-based collateral is short in the system, people are clamoring for dollars."