The United States is currently grappling with its most severe inflation crisis in four decades, prompting the Federal Reserve to consider accelerating interest rate hikes and trimming its balance sheetThese measures have led to a swift rise in U.STreasury yields, resulting in increased volatility in the stock marketThe implications of this tightening cycle on global financial markets are expected to be more significant than those observed during the last tightening period.

As the new year commenced, global markets found themselves in a state of despondencyBoth the Chinese and American stock markets witnessed varying degrees of declineBy January 19, the S&P 500 index had fallen by 4.9% year-to-date, while the Nasdaq index plummeted over 8%. In China, the Shanghai Composite Index dropped by 2.24%, and the ChiNext Index fell by 7.42%.

Despite the similar market conditions, investors on either side of the Pacific express differing concerns

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Chinese investors are particularly anxious about the stability of the real estate market and whether the government's growth-stabilizing policies will adequately cushion the economic downturnMeanwhile, their American counterparts worry about the effectiveness of measures to control inflation, with an increasing number of indicators suggesting that the Fed is tightening monetary policy at an unprecedented pace.

In December 2021, the U.SConsumer Price Index (CPI) year-on-year rose by 7.0%, marking the largest increase since June 1982 and signifying a daunting inflation crisis for the United StatesThe core CPI also witnessed a year-on-year rise of 5.5%, the highest since February 1991, highlighting the extraordinary nature of current inflationary pressures.

In light of the soaring inflation, the Fed is expected to raise interest rates more frequently and expedite the reduction of its balance sheet

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Recently nominated Federal Reserve Vice Chair Lael Brainard, traditionally seen as dovish, hinted that a rate hike could occur as early as March 2022.

Historically, the Fed's tightening measures have been driven by robust economic recovery and strong employment gainsHowever, this time, the central bank faces an uphill battle against high inflationThe character and speed of the Fed’s monetary policy adjustments have shifted significantly from previous patterns, making global financial markets more susceptible to fluctuation.

The acceleration of the Fed's tightening policy signals a marked change from expectations set just a couple of months priorBack in November, when the Fed announced its tapering strategy, many viewed rate hikes and balance sheet reductions as distant prospectsAnalysts were generally forecasting only one or two rate hikes in 2022, with any balance sheet normalization not anticipated until 2023.

However, financial realities have quickly transformed these projections

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Continuing rises in inflation and the largest inflation rates in nearly four decades have placed immense pressure on the FedEconomic experts have pointed fingers at the Federal Reserve, claiming that it has been too lenient on inflationKenneth Rogoff, often dubbed the 'doom economist', publicly criticized Fed Chair Jerome Powell for failing to take decisive actions against inflation concernsFormer U.STreasury Secretary Larry Summers echoed this sentiment, asserting that the Fed had underestimated the challenges posed by rising inflation levels.

By December 2021, a dot plot of interest rate forecasts showed that policymakers were expecting three rate hikes in 2022. As more Fed officials advocate for a series of aggressive hikes, the prevailing sentiment among them has shifted toward a more hawkish approach.

Christopher Waller, a member of the Fed Board, recently stated that three rate hikes in 2022 represent a “reasonable baseline scenario,” suggesting the possibility of four or even five hikes if inflation remains persistently high

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Patrick Harker, president of the Federal Reserve Bank of Philadelphia, also indicated his support for potentially four hikes if inflation goes uncheckedBullard, another voting member, similarly acknowledged that four hikes were likely.

However, rate hikes alone may not suffice; a balance sheet reduction looms on the horizon as well, setting the stage for a dual tightening effectOn January 5, the Fed published the minutes from its December meeting, revealing a predominantly hawkish tone amongst officials, many of whom mentioned the timing for balance sheet reductionsNearly all participants agreed that initiating balance sheet normalization soon after a rate hike was appropriate, suggesting that rapid reductions could occur compared to past normalization periods.

During the discussion about the balance sheet, Powell commented on its substantial growth and indicated that shrinkage would likely be both earlier and quicker than in previous instances.

Goldman Sachs has forecasted that the Fed will proceed with four interest rate hikes throughout the year—specifically in March, June, September, and December—while starting to reduce its balance sheet in July.

The differences between tightening through interest rate hikes and balance sheet reductions are notable

According to Changjiang Securities, these mechanisms can be distinguished by four primary factors:

Firstly, they employ distinct toolsRate hikes pertain to price-based tools, while balance sheet reductions involve quantity-based mechanisms, each affecting funding prices and amounts differently.

Secondly, they influence the economy through different mechanismsRate hikes mainly adjust the federal funds target rate which, through open market operations, brings the federal funds rate in line with the target, thereby affecting short-term borrowing costs and regulating liquidity and the economyIn contrast, balance sheet reductions mean not rolling over maturing assets, leading to a gradual shrinking of the balance sheet as maturing assets increaseThis not only reduces Fed assets but also diminishes excess reserves on the liability side, which directly impacts liquidity in the money market.

Thirdly, the timing of their effects differs

Rate hikes immediately influence short-term interest rates, affecting overnight lending rates, whereas balance sheet reductions depend on the size of maturing assetsGiven that the Fed holds primarily medium- to long-term treasuries and mortgage-backed securities, balance sheet reductions may not lead to rapid decreases in total balance sheet size.

Finally, the magnitude of their effects also variesHistorically, rate hikes have more direct ramifications on overall economic activity, as they impact borrowing costs directly, dampening the willingness of individuals and enterprises to take out loansConversely, balance sheet reductions primarily diminish liquidity in the money market, exerting more indirect effects on the economy.

This tightening phase is proving to be quite distinct from previous ones

The last tightening cycle (from late 2013 to early 2019) serves as a typical reference point; while history can offer insights, it should not be viewed as a mere template for replication.

In the past tightening cycle, the Fed operated with a measured, phased approach: first tapering, followed by rate hikes, and finally tapering balance sheetsEach step was separated by considerable time gaps, reflecting a cautious and deliberate attitude.

Conversely, the Fed’s current tightening measures appear poised to be more immediateIf balance sheet reductions commence mid-2022, the gap from tapering to reductions could shrink to just 8-9 months, in stark contrast to the four-year interval during the last cycle.

Moreover, current circumstances are unprecedented, as the Fed is potentially confronting its first genuine inflation challenge since the 1970s

The central bank appears somewhat unfamiliar with navigating these treacherous waters, leaving its ability to manage the current environment in question.

There are notable distinctions in the financial landscape compared to the last cycle that suggest that the ramifications of this balance sheet reduction might substantially impact the marketsAnalysts at Zhongtai Securities indicate that whether through active or passive reductions, demand for U.STreasury bonds from the Fed will likely diminishCurrent tapering trends already reveal weakening demand in the Treasury market, and balance sheet reductions will likely exacerbate this situationHikes are expected to influence shorter-term rates significantly, while reductions could push longer rates higher.

As the Fed steps back as the largest buyer of U.S