CICC: “Monetary and Fiscal Coordination” under the Walsh Reform

The Zhitong Finance App learned that CICC released a research report saying that Walsh is using five working groups as a starting point to push forward the reform of the monetary policy framework in an attempt to match the targeted investment of liquidity between finance and banks under the new framework, and to help overcome falsehood and become realistic through the “monetary and fiscal collaboration” that Walsh has emphasized many times. Under the new framework, the Walsh reforms seek to reduce financing costs through regulation, collaborate with fiscal goals, and help capital flow where it is needed more.

As the US government and strategic industries increasingly rely on debt financing, monetary policy will have to be balanced in terms of trend price. CICC determines that the monetary policy framework will be adjusted as follows:

In terms of policy interest rates, we are focusing more on endogenous inflation that monetary policy can and must adjust, mainly brought about by the economic cycle, such as wages, to mitigate systemic shocks such as geographical conflicts and structural inflation caused by the AI investment boom. As a result, the threshold for interest rate hikes was raised and the threshold for interest rate cuts was lowered. Furthermore, as fiscal financing becomes more reliant on short-term debt, policy interest rates will also take more into account the debt interest burden, rather than being based solely on economic fundamentals.

In terms of balance sheets, the Federal Reserve will shift from actively regulating liquidity in the QE/QT era to passively expanding statements and investing in base currencies in line with finance and banks. Specifically, in cooperation with the Ministry of Finance in issuing short-term bonds, we will continue to use reserve management and purchase operations to expand the RMP trend to buy short-term bonds. At the same time, banks are encouraged to strengthen the use of the Federal Reserve's credit instruments through bank supervision, activate bank credit and US bond market-making functions, and release banks' long-term space. In summary, CICC expects the Federal Reserve to expand its financial statements on a trend, but the asset structure gradually changed from the previous long-term US bonds and MBS to short-term assets such as short-term bonds and bank credit instruments; as a result, liquidity investment also changed from large open and large consolidation to a narrow flow of water.

Problems with the QE/QT liquidity system

The US dollar liquidity framework established after the 2008 financial crisis. Liquidity in the narrow sense means that the absolute amount of bank reserves remains “abundant”. The Federal Reserve mainly adjusts the size of reserves less and more through QE/QT, without the need to anchor federal funds interest rates by frequently adjusting reserve supply as before the financial crisis [1].

There are three major structural problems with this system:

1) At the source of liquidity: Expanding liquidity can easily trigger excessive financial speculation and risk accumulation, that is, the Federal Reserve's long-term QE (quantitative easing) actively releases liquidity. It is large-scale and fast, often leading to excessive liquidity loosening, triggering excessive financial speculation; then, drastic QT (quantitative austerity, downsizing) is overdone, eventually triggering liquidity and even financial risk before starting a new round of QE (Chart 1).

2) Interest rate and communication policy: Continued high-frequency communication with the market has led to strengthened feedback on market expectations and the Federal Reserve's policy. That is, once the Fed tightens beyond expectations, it will cause market fluctuations and even financial risks, and the policy will eventually compromise and continue to shift pigeons (so-called “Fed Put Options”, Chart 2).

3) Targets of supervision: Excessive supervision of the banking industry, requirements such as supplementary leverage ratio (SLR), liquidity ratio (LCR), and intraday liquidity monitoring (intraday liquidity monitoring) have largely limited banks' ability to stabilize financial markets (market-making business) and expand credit (traditional deposit and loan business), while there is no effective supervision of non-banks (such as hedge funds), and non-bank institutions increase leverage, and risks become more unobservable.

Chart 1: The size of reserves fluctuates greatly around the level of sufficiency, and when insufficient, it often triggers a liquidity crisis

Source: Federal Reserve, CICC Research Division

Chart 2: The Federal Reserve's monetary policy is increasingly concerned with the stock market

Source: Cieslak, A., & Vissing-Jorgensen, A. (2021), CICC Research Division

And these structural problems are fueling America's transformation from reality to fiction:

For financial institutions, excess liquidity during the QE stage stimulates asset bubbles; excessive leverage increases the fragility of the financial system, and drastic tightening of liquidity triggers financial risks, which in turn forces new QE [2], leading to larger asset appreciation (Chart 1). Thus, not only did monetary policy fall into the state of excessive control (“mission creep”) that Walsh criticized [3], but the policy itself has instead become an important source of preparing and penetrating financial risks [4].

For the real economy, strict banking supervision has hindered traditional SME access to financing [5], while the rise of non-bank financing and lower long-term interest rates have stimulated large enterprises capable of capital market financing [6]. The large amount of US dollars released through QE has flowed more into “arbitrage” by non-bank institutions and large technology platform-based companies, intensifying the “dissolution from reality to fiction.”

Structural Constraints of the Walsh Reforms

Faced with the problems of the old system, reform seems imperative. Since being nominated as the chairman of the Federal Reserve, Walsh has frequently sent downsizing signals and caused market shocks. However, according to CICC's judgment, this “downsizing” is by no means a “downsizing” of the other. Faced with structural constraints from various dimensions such as finance, economy, and markets, it is difficult to achieve by simply “reducing the nominal size of the Federal Reserve's balance sheet.” These restrictions may even force monetary policy to be more cooperative.

First, the “small government” came to an end, “big finance” was restarted, and the pressure to finance US debt was high. Since the 1980s, the trend of “heavy money, light finance” has been accompanied by the hollowing out of the US industry, financialization, and the division between rich and poor (Chart 3). These issues triggered a sharp rebound in public opinion after the 2008 financial crisis [7]. In recent years, the United States has developed pro-cyclical big finances. An important factor is the growing demand for national security, functional industrial policies, and redistribution policies (such as the “Big Three Bills” during the Biden administration, and the “Big and Beautiful Act” last year). Looking ahead, even according to the CBO's conservative estimates, the high deficit rate will continue for a long time (Chart 4). Fiscal financing (US bond issuance) imposes hard restrictions on monetary policy from both price and volume perspectives (Chart 5, Chart 6), making it difficult to substantially tighten the currency, and even expand in line with finance (for example, starting RMP in December last year). Walsh himself has stated many times that the US Federal Reserve, which is in charge, will strengthen coordination with finance [8]. Research within the Federal Reserve also suggests that attention should be paid to the impact of US debt financing on liquidity, and that the tightening effect of debt issuance on liquidity should be hedged by purchasing short-term bonds [9].

Chart 3: Since the 1980s, America's “small government” has been accompanied by industrial hollowing out and the gap between rich and poor widened

Source: FRED, CICC Research Division

Chart 4: The US Treasury is likely to continue

Source: CBO, Tax Foundation, CICC Research Division

Chart 5: The pressure on US fiscal interest spending is rising rapidly

Source: CBO, CICC Research Division

Chart 6: Liquidity tightened as a result of fiscal financing pressure

Source: FRED, CICC Research Division

Second, the financing pressure for AI and re-industrialization investments. By betting on AI investment to increase productivity, drive re-industrialization, and address global geopolitical challenges, it has gradually become the main line of industrial policies in various countries (“Major Asset Migration: Redefining Safe Assets”). CICC believes that this means that the boom dominated by AI investment may span the general economic cycle, and as the free cash flow of related enterprises gradually runs out, investment will increasingly rely on financial market financing. CICC predicts that net corporate bond financing is expected to exceed 2 trillion US dollars in the next year, and bank-to-non-bank loans involving private equity credit are expected to continue to increase by 330 billion US dollars (Chart 7, Chart 8). Corresponsibly, banks' market making and credit demand will also increase. If cash (that is, reserves) in banks' hands is excessively tightened at this time, it will hinder the smooth progress of financing and even cause liquidity risks.

Chart 7: Net issuance of corporate bonds continues to rise

Source: Bloomberg, CICC Research Division

Chart 8: Bank-to-non-bank loans are growing rapidly, reflecting strong demand for private equity credit

Source: FRED, CICC Research Division

The fragility of the financial system itself determines that liquidity reform must be cautious. Mainstream central bank research shows that the minimum size of a central bank's balance sheet is essentially determined by the financial system's minimum demand for reserves [10]. Looking at it now, whether based on the rule of thumb given by Federal Reserve Governor Waller (sufficient reserves are about 10%-11% of the nominal US GDP [11], chart 1) or the warning line given by the Federal Reserve's research (reserves account for 65% of the bank's daily FedWire transfers [12], chart 9), the size of reserves is already on the verge of being relatively insufficient. In the US bond issuance wave from July to December last year, general fiscal accounts returned to reserves, causing interest spreads in the repurchase market to rise sharply (Chart 10), forcing the Federal Reserve to begin RMP expansion (“Fiscal Leadership, Restart Schedule Expansion”). In May of this year, Federal Reserve Governor Michael S. Barr (Michael S. Barr), who has long been responsible for overseeing the banking industry and liquidity issues, publicly stated that simply aiming to reduce the size of balance sheets is wrong, and that forcibly weakening bank liquidity regulations would endanger the stability of the financial system [13].

Chart 9: The ratio of reserves to FedWire transfers has fallen below the warning line

Source: Haver, CICC Research Division

Chart 10: The repurchase market experienced significant financing pressure during the US bond issuance wave in July last year

Source: FRED, CICC Research Division

Walsh's Countermeasures: A New Type of “Monetary and Fiscal Coordination”

break the old and start a new

In response to these restrictions, CICC observed that Walsh adopted a reform path of “breaking the old and building a new one.” That is, criticizing the old rules, establishing new rules, and constructing independence on top of the new rules, and following the new rules can naturally meet the financing constraints and financial stability requirements described above, without excessive tightening of monetary policy. This is reflected in the establishment of three working groups: the inflation framework, economic data, productivity, and employment:

Inflation Framework Working Group: Team leader Sargent (Sargent) believes that inflation is the result of a combination of finance and currency. If the fiscal deficit gets out of control, monetary policy alone cannot control inflation [14]. Team leader Mankiw (Mankiw) advocates ranged inflation [15] and inflation changing anchors [16]. In the K-type economy, investment inflation and wage deinflation occur simultaneously, and if Mankun's view is adopted, the inflation indicators provided by the private market and wage levels are anchored, then the weakness and de-inflation of the lower K branch cannot be ignored (Chart 11, Chart 12);

Economic Data Working Group: Team leader Raj Chetty (Raj Chetty) believes that traditional macroscopic aggregate data has smoothed out structural differences. Through micro big data such as credit cards and real-time job postings, the real economic temperature of different classes and regions can be directly observed [17]. Essentially, this is also a desire to change the anchor, and if viewed structurally, the resilience of particularly traditional sectors of the US economy is not optimistic, nor can it support continued austerity (see “Global Markets in the Second Half of the Year: Trading “Lagging Curve”);

Productivity and Employment Working Group: Team leader Anderson paid attention to the possibility that AI investment could trigger a supply-side productivity explosion over a long period of time, thereby reducing costs and suppressing inflation [18]. The reasonable deduction, then, is that more patience should be given to such supply-side inflationary factors, rather than directly killing investment demand in the cradle according to traditional policy ideas during the period when financing is needed.

Chart 11: Truflation core inflation trending downward year on year

Source: Bloomberg, CICC Research Division

Chart 12: The year-on-year trend in unit labor costs is declining

Source: FRED, CICC Research Division

As you can imagine, the new framework finally proposed by the team leader selected and appointed by Walsh will, to a large extent, facilitate AI financing (and financial financing to support industrial policy) and effectively care for the lower half of the K-type branch. As Walsh continues to criticize monetary policy for managing too much [19], CICC believes that the new rules may leave more issues that the Fed cannot handle, such as dealing with supply shocks (such as oil prices), to the White House, and that monetary policy will return to its original roots, that is, to provide a stable monetary background for economic operation and prevent monetary policy itself from becoming the source of economic turmoil [20].

Liquidity Investment Mechanisms: From the Federal Reserve's initiative to cooperating with finance and banks

Obviously, excessive easing and excessive austerity, such as QE/QT in the past, did not meet this original goal. So, specifically, how will Walsh adjust its liquidity framework? The answers are hidden in the Balance Sheet Task Force and Milan's March “User Guide to Reducing the Federal Reserve Balance Sheet” (“Guide”). Jeremy Stein (Jeremy Stein), co-head of the Balance Sheet Working Group, argues that there is no need to mechanically shrink the balance sheet; structural adjustments such as asset longevity are more important than large-scale pressure drops [21], and that the exit process should focus on financial stability [22]. In terms of specific policies, CICC believes that the so-called balance sheet reform essentially gradually revises the liquidity framework by easing regulations on the banking industry. This may involve several core changes:

First, in terms of how to release liquidity, end the QE/QT model and make liquidity release passive, refined, and routine. Specifically, the release of liquidity will shift to a model where finance, banks, and other foreign-funded institutions actively apply and the Federal Reserve passively cooperate: on the fiscal side, the “Guidelines” section 12 policy (chart 13) and the Federal Reserve's internal study in August last year [23] all suggest that during the period when fiscal debt issues occupy reserves, they release an equal amount of liquidity to the market (fiscal initiative, cooperation from the Federal Reserve); for banks, sections 1, 3, and 11 of the “Guidelines” are ways to encourage “stigmatization” and extension of borrowing periods Banks are in demand Actively and routinely borrow money from the Federal Reserve in cash. Essentially, the Federal Reserve will cooperate with banks to expand their inventories and invest in the base currency. Liquidity release achieved based on this method has costs (adjusted by interest rate policies). It is more about meeting marginal liquidity needs of finance and banks. The frequency of adjustments is high, the scale of each adjustment is small, and more detailed.

Second, by shortening the balance sheet period, the Federal Reserve may have to hold more short-term bonds and release long-term bonds to banks and other financial institutions. Walsh's criticism of QE is based more on the belief that buying long-term bonds distorts asset pricing [24], so the Federal Reserve may continue to release long-term assets to the market. However, as mentioned earlier, “downsizing” takes into account the carrying capacity of the financial market, because once financial risks arise, it will force the Federal Reserve to buy long-term bonds or even QE again. CICC believes that Walsh may achieve long-term reduction through long-term and short-term replacements: Walsh did not suspend RMP after coming to power, but instead continued to reduce his MBS holdings and increase his short-term debt holdings, essentially shortening the asset period. Articles 6 and 12 of the “Guide” also confirm the legitimacy of releasing liquidity through short-term debt.

Of course, it is still difficult to absorb long-term bonds released by the Federal Reserve alone. This requires the third point: banks to regulate (increase their ability to hold debt) and create profit margins for banks to hold debts (provide room for regulatory arbitrage and increase willingness to hold debts). Walsh has expressed support for the relaxation of banking regulations in several public forums [25] and hopes to divest the Federal Reserve from overseeing banks and return power to the US Treasury [26]. Specifically, most of the policy recommendations in the “Guidelines” point to removing excessive liquidity and capital supervision requirements for the banking industry. The reason is obvious. If the liquidity coverage requirement falls (there is no need to keep too much cash) and banks are allowed to increase leverage (which can increase risk exposure), banks will reduce their cash ratio and hold more assets with higher returns. Furthermore, if US bonds can be pledged in an SRF or discount window to obtain long-term stable refinancing, banks have the need for leveraged arbitrage (that is, buying long-term bonds, pledging refinancing in the SRF window, holding maturity to earn interest spreads between long-term bonds and policy interest rates, and amplify them through increased leverage), then demand for long-term bonds may also increase. When long-term bond yields are roughly framed by this, long-term capital in the US is also more willing to hold long-term bonds, which is expected to stabilize or even lower long-term interest rates.

Chart 13: Milan's “Downsizing Guide” gives key details of the liquidity system reform

Source: “User Guide to Reducing the Federal Reserve Balance Sheet”, CICC Research Division

A new type of “monetary and fiscal coordination”

Based on the above reform picture, Walsh has actually achieved a new type of more hidden monetary co-finance. Unlike last year's relatively simple, executive order-based approach where Trump suppressed the independence of the Federal Reserve [27], required two houses to buy MBS [28], and required banks to limit credit card interest rates [29], Walsh's monetary coordination is based on rules and systems.

In terms of interest rate policy, according to its newly established inflation and economic data anchor, as well as considerations for improving long-term supply efficiency, the Federal Reserve may consider not raising interest rates as appropriate when related commodities are inflated but wages are inflated due to geographical conflicts and investment boom, and may continue to cut interest rates after the oil price problem is mitigated.

In terms of quantitative policies, on the one hand, it limits the expansion of liquidity, and also ensures that finance and financial institutions continue to have smooth access to capital in small amounts, many times, and on the margins. Judging from the results, the Federal Reserve will cooperate with finance and banks to continue to expand their accounts, and banks will also accelerate their expansion. Liquidity delivery channels are expected to be smoother and more accurate.

In terms of financial supervision, the ability of banks to expand their accounts is increased through bank supervision, and at the same time, banks' supervisory responsibilities are ceded to finance. At the same time as monetary and fiscal coordination, banks expand their accounts under financial supervision to facilitate banks, as market makers, to cooperate with fiscal debt issuance, or to target the release of capital to the real economy in accordance with industrial policies. In fact, they provide specific financial instruments for functional finance, making it easy for them to achieve the idea of breaking away from reality and returning to the manufacturing industry.

Chart 14: Under the new framework, the Federal Reserve passively matches fiscal and bank financing needs and is expected to expand the table trend, and banks are expanding their tables at an accelerated pace

Note: In order to show changes in the framework, the balance sheet has been greatly simplified in the chart

Source: CICC Research Division

What CICC would like to note is that even under the new framework, the Federal Reserve's status as the “last market maker” cannot be shirked. Since the long-term bond yield center follows the nominal economic growth center (Chart 15), if this monetary coordination framework is implemented and short-term interest rates continue to be lowered to stimulate the economy, long-term bond yields may instead rise. Under such circumstances, there is no direct intervention or indirect guarantee from the Federal Reserve; instead, banks and other private financial institutions only absorb US debt; it may be difficult to effectively suppress long-term bond yields and avoid stepping on risk situations (Chart 16). Therefore, the Federal Reserve still needs to act as the final market maker. In fact, what Walsh himself opposed was only normalized QE, not starting QE in times of crisis to provide emergency liquidity to the market [30].

Chart 15: The long-term bond yield center follows the nominal growth center

Source: Bloomberg, CICC Research Division

Chart 16: Private debt holdings are difficult to avoid being trampled upon, and the Federal Reserve's status as the last market maker is difficult to dismiss

Note: Elasticity is the percentage of the 10-year US Treasury yield rising by 1 bps corresponding to a decline in the holding ratio. Negative values reflect a reduction in US debt holdings when yields rise

Source: FRED, CICC Research Division