CICC: "Monetary and Fiscal Coordination" under the Walsh Reforms

CICC released a research report stating that Waller is pushing for reforms to the monetary policy framework through five working groups, attempting to coordinate fiscal policy and targeted liquidity injections by banks under a new framework. This is aimed at facilitating a shift from virtual to real economies through what Waller has emphasized as "money-fiscal coordination." In the new framework, the Waller reforms seek to standardize the reduction of financing costs in collaboration with fiscal goals, helping direct funds to areas in greater need. As the U.S. government and strategic industries increasingly rely on debt financing, monetary policy will need to align with trends in price and quantity. CICC predicts the following adjustments to the monetary policy framework: In terms of policy interest rates, there will be a greater focus on endogenous inflation primarily driven by economic cycles, such as wages, while downplaying systemic shocks like geopolitical conflicts and the structural inflation caused by the AI investment boom. Consequently, the threshold for raising interest rates will be increased, while the threshold for lowering rates will be reduced. Moreover, as fiscal financing becomes increasingly reliant on short-term debt, policy interest rates will also take into account the burden of debt interest, rather than being solely based on economic fundamentals. Regarding the balance sheet, the Federal Reserve will shift from actively controlling liquidity during the QE/QT era to passively coordinating with fiscal and banks to expand the balance sheet and inject base money. Specifically, in collaboration with the Treasury's short-term debt issuance, it will continue the reserve management purchasing operation (RMP) trendily by buying short-term debt. Additionally, by loosening regulations, banks will be incentivized to use Federal Reserve credit tools more effectively, activating their credit and U.S. Treasury market-making functions, creating more duration space for banks. In summary, CICC expects the Federal Reserve's balance sheet to expand trend-wise, but the asset structure will gradually shift from long-duration U.S. Treasury bonds and MBS to short-term debt and short-duration bank credit instruments; as a result, liquidity injections will change from being episodic to more consistent. Issues within the QE/QT liquidity framework The dollar liquidity framework established after the 2008 financial crisis has maintained "ample" absolute amounts of bank reserves, with the Federal Reserve mainly adjusting the reserve scale through QE/QT in fewer, larger doses, rather than frequently adjusting reserve supply to anchor the federal funds rate as before the financial crisis. This system presents three structural issues: 1) At the source of liquidity: Excessive liquidity opens the floodgates for financial speculation and risk accumulation. That is, the Federal Reserve's long-term QE actively releases liquidity large in scale and rapid in pace often resulting in overly loose liquidity that triggers excessive financial speculation; followed by significant QT that corrects this by over-tightening, eventually leading to liquidity or financial risks, prompting a new round of QE. 2) On interest rates and communication policy: The continuous high-frequency communication with markets leads to a strong feedback effect between market expectations and Federal Reserve policies. Once the Federal Reserve tightens more than expected, it triggers market volatility or even financial risks, ultimately leading to policy compromise and a return to dovish stances (referred to as the "Federal Reserve put"). 3) On regulation targets: Excessive regulation of the banking sector, including requirements like the supplementary leverage ratio (SLR), liquidity coverage ratio (LCR), and intraday liquidity monitoring, greatly restricts banks' abilities to stabilize financial markets (market-making activities) and expand credit (traditional deposit and loan operations), while there is a lack of effective supervision over non-bank entities (such as hedge funds), leading to greater risk exposure that becomes less observable. Chart 1: Reserve sizes fluctuate significantly around ample levels, often triggering liquidity crises when insufficient Source: Federal Reserve, CICC Research Department Chart 2: The Federal Reserve's monetary policy increasingly considers the stock market Source: Cieslak, A., & Vissing-Jorgensen, A. (2021), CICC Research Department These structural issues contribute to the U.S. trend of shifting from real to virtual: For financial institutions, the surplus liquidity during the QE phase led them to "search for yield," fueling asset bubbles. Excessive leverage increased the vulnerabilities within the financial system; significant QT tightening liquidity triggered financial risks, thus forcing new QE, which resulted in even larger-scale asset appreciation. Therefore, monetary policy has not only fallen into what Waller criticized as an over-regulated state (referred to as "mission creep"), but the policy itself has also become an important source of brewing and bursting financial risks. For the real economy, stringent regulation of banks has impeded traditional small and medium enterprises' access to financing. The rise of non-bank financing alongside lower long-term interest rates has favored large companies capable of capital market financing. A large amount of dollars released through QE has flowed more into non-bank entities for "arbitrage" and large tech platform corporations, exacerbating the shift from real to virtual. Structural Constraints of Waller's Reforms In light of the old system's issues, reforms seem imperative. Since being nominated as Fed Chair, Waller has frequently signaled a reduction in the balance sheet, causing market volatility. However, CICC assesses that this "balance sheet reduction" is not the same as previous instances, as Waller faces various structural constraints from dimensions such as fiscal policy, economics, and markets, making it difficult to achieve merely by simply cutting the nominal size of the Federal Reserves balance sheet. These constraints may even compel monetary policy to better coordinate with fiscal objectives. First, the end of "small government" and the restart of "big fiscal" have placed significant pressure on U.S. Treasury financing. Since the 1980s, a trend of "heavy on money, light on fiscal" has accompanied the hollowing out of American industries, financialization, and wealth disparity. These issues sparked a strong public backlash following the 2008 financial crisis. In recent years, the U.S. has witnessed a cyclically expansive fiscal policy, driven significantly by increasingly strong demands for national security, functional industrial policies, and redistribution policies (such as major legislation during the Biden administration and last year's "Big and Beautiful Act"). Looking ahead, even according to conservative CBO estimates, the high deficit rates are likely to persist long-term. Fiscal financing (Treasury issuance) presents hard constraints on monetary policy from both price and quantity perspectives, making it challenging for monetary policy to significantly tighten and necessitating expansion to support fiscal efforts. Waller himself has repeatedly indicated that the Fed under his leadership will enhance coordination with the Treasury, and internal Federal Reserve research acknowledges that it should consider the liquidity impacts of Treasury financing, offsetting the tightening effects of debt issuance through purchasing short-term debt. Chart 3: Since the 1980s, the U.S.'s "small government" has accompanied industrial hollowing and widening wealth gaps Source: FRED, CICC Research Department Chart 4: The likelihood of enduring U.S. fiscal expansion remains high Source: CBO, Tax Foundation, CICC Research Department Chart 5: U.S. fiscal interest expenditure pressure is rapidly rising Source: CBO, CICC Research Department Chart 6: Fiscal financing pressure triggers liquidity tightening Source: FRED, CICC Research Department Secondly, financing pressures from AI and re-industrialization investments. Betting on AI investments to enhance productivity and promote re-industrialization has gradually become a central aspect of industrial policies in various countries in response to global geopolitical challenges. CICC believes this means that AI-driven investment booms could transcend typical economic cycles, and as the free cash flow from relevant enterprises diminishes, their investments will increasingly rely on financing from financial markets. CICC predicts that corporate bond net financing could surpass $2 trillion in the coming year, with bank lending to non-banks in private credit likely increasing by $330 billion. Consequently, bank market-making and credit demand will also grow. If liquidity at banks is overly tightened at this juncture, it may obstruct smooth financing and even lead to liquidity risks. Chart 7: Corporate bond net issuance continues to rise Source: Bloomberg, CICC Research Department Chart 8: Bank lending volume to non-banks is rapidly increasing, reflecting robust private credit demand Source: FRED, CICC Research Department The inherent vulnerabilities of the financial system dictate that liquidity reforms must be approached cautiously. Mainstream central bank research indicates that the minimum size of a central bank's balance sheet is fundamentally determined by the financial system's minimum demand for reserves. Presently, both based on the rule of thumb provided by Federal Reserve Governor Waller (adequate reserves are approximately 10%-11% of U.S. nominal GDP) and the alert line indicated by Federal Reserve research (reserves should constitute 65% of daily FedWire transfer volumes), reserve levels are nearing inadequacy. During the surge in Treasury issuances from July to December of last year, the Treasury's general account reclaimed reserves, significantly raising repo market spreads and compelling the Federal Reserve to activate RMP expansion. In May this year, Michael S. Barr, the Federal Reserve Governor responsible for overseeing the banking sector and liquidity issues, publicly stated that having a sole focus on reducing the balance sheet size is misguided, and forcefully weakening bank liquidity regulatory rules could jeopardize financial system stability. Chart 9: The ratio of reserves to FedWire transfers has fallen below the alert line Source: Haver, CICC Research Department Chart 10: Clear financing pressures emerged in the repo market during last July's Treasury issuance surge Source: FRED, CICC Research Department Wallers Response: A New Type of "Monetary-Fiscal Coordination" Break the old and establish the new In response to these constraints, CICC observes that Waller has adopted a "break the old and establish the new" reform approach. This involves criticizing the old rules and establishing new ones, building independence upon these new rules so that they naturally satisfy the aforementioned financing constraints and the requirements for financial stability without excessively tightening monetary policy. This is reflected in the establishment of three working groups covering inflation frameworks, economic data, productivity, and employment: Inflation Framework Working Group: Chair Sargent contends that inflation is the result of the combined effects of fiscal and monetary policies, asserting that uncontrolled fiscal deficits cannot be restrained solely by monetary policy. Chair Mankiw advocates for a range of inflation and inflation re-anchoring. In a K-shaped economic state, investment inflation and wage disinflation appear simultaneously, and if adopting Mankiw's viewpoint of using private market inflation indicators anchored to wage levels, the fatigue and disinflation on the K-shaped lower tier cannot be overlooked. Economic Data Working Group: Chair Raj Chetty argues that traditional macroeconomic aggregate data smooths over structural differences, advocating the use of micro data from sources such as credit cards and real-time job postings to directly observe the real economic conditions across different classes and regions. Essentially, this also seeks re-anchoring, and viewed structurally, the resilience of the traditional sectors of the U.S. economy remains concerning and unable to withstand continued tightening. Productivity and Employment Working Group: Chair Anderson emphasizes the long-term potential of AI investments to spark supply-side productivity explosions, thereby lowering costs and suppressing inflation. Hence, it stands to reason that for this supply-side disinflation factor, greater patience should be exercised, rather than stifling investment demand with traditional policy approaches during periods when financing is necessary. Chart 11: Truflation core inflation year-on-year trend declining Source: Bloomberg, CICC Research Department Chart 12: Unit labor costs year-on-year trend declining Source: FRED, CICC Research Department It can be imagined that the new framework ultimately provided by the leaders chosen and appointed by Waller will greatly favor AI financing (as well as fiscal financing supporting industrial policy) and effectively nurture the lower half of the K-shaped curve. Just as Waller has continuously criticized monetary policy for overmanagement, CICC anticipates the new rules may increasingly shift the responsibility for addressing supply shocks (such as oil prices) and other issues beyond the Federal Reserve's scope to the White House. Monetary policy would then return to its roots, as articulated by monetarist founder Friedman: providing a stable monetary backdrop for the economy to operate while avoiding the monetary policy itself becoming a source of economic turbulence. Liquidity Injection Mechanism: From Active Fed Intervention to Coordination with Fiscal and Banks It is evident that neither excessive looseness nor excessive tightening akin to previous QE/QT phases meets the original objectives. So, specifically, how will Waller adjust the liquidity framework? The answer lies within the balance sheet working group and in the March user's guide titled "Reducing the Federal Reserve's Balance Sheet" authored by then-Federal Reserve Governor Milan. Co-chair of the balance sheet working group, Jeremy Stein advocates against mechanically shrinking the balance sheet, emphasizing that structural adjustments in asset duration are more important than scale reductions, and that the exit process should focus on financial stability. In specific policy terms, CICC believes that the so-called balance sheet reform essentially aims to gradually modify the liquidity framework through easing regulations on the banking sector, which may involve several core changes: First, regarding the method of releasing liquidity, the QE/QT model will conclude, transitioning liquidity release to a passive, refined, and routine practice. Specifically, liquidity release will shift to a model where fiscal authorities, banks, and other foreign institutions proactively request liquidity, while the Federal Reserve passively cooperates: On the fiscal side, both the twelfth policy from the "guide" and internal Federal Reserve research from last August suggested releasing liquidity into the market equivalent to the amount of Treasury bonds purchased during periods when fiscal debt issuance occupies reserves (fiscal-driven, Federal Reserve-coordinated); for banks, the first, third, and eleventh policies in the "guide" aim to encourage banks to actively and routinely borrow from the Federal Reserve through measures such as "de-stigmatization" of the discount and SRF windows and extending borrowing terms. Essentially, the Federal Reserve will cooperate with banks in expanding their balance sheets and injecting base money. Liquidity release achieved through this model comes with costs (regulated by interest rate policies) and primarily meets the marginal liquidity needs of fiscal and banks, with more frequent adjustments that are smaller in scale and more refined. Second, regarding the duration of the balance sheet, the Federal Reserve may hold more short-term debt while releasing long-term bonds for banks and other financial institutions to hold. Waller's criticism of QE primarily pertains to the distortion of asset pricing caused by purchasing long-term bonds; hence, the Federal Reserve may continue to release long-term assets into the market. However, as mentioned earlier, the "balance sheet reduction" must consider the financial market's absorption capacity, because the emergence of financial risks could compel the Federal Reserve to repurchase long-term bonds or even reactivate QE. CICC believes that Waller may implement duration compression through a long-short swap strategy: after taking office, Waller did not pause RMP but rather continued to reduce MBS holdings while increasing short-term debt, effectively shortening the asset duration. The sixth and twelfth policies of the "guide" also affirm the legitimacy of releasing liquidity via short-term debt. Of course, relying solely on the Federal Reserve to purchase short-term debt still lacks the capacity to absorb the long-duration bonds released by the Federal Reserve, which brings us to the third point: loosening bank regulations (enhancing holding capacity) and creating profit margins for banks holding bonds (providing regulatory arbitrage opportunities to increase their willingness to hold bonds). Waller has expressed support for loosening banking regulations in various public forums, hoping to relinquish the Federal Reserve's regulatory role over banks and return power to the U.S. Treasury. Specifically, most recommendations from the "guide" aim to relieve the banking sector of excessive liquidity and capital requirements. The rationale is evident: if the liquidity coverage ratio requirement decreases (not requiring banks to hold too much cash), while also allowing banks to leverage (increasing risk exposure), banks will reduce their cash ratios and instead hold more higher-yielding assets. Furthermore, if banks can pledge U.S. Treasury bonds in the SRF or discount window for long-term stable refinancing, they will then have a demand for leveraged arbitrage (i.e., purchasing long-term bonds, pledging them in the SRF window for refinancing, and holding them until maturity to earn the interest rate spread between long-term bonds and policy rates), thus potentially increasing demand for long-term bonds. Once the yields on long-term bonds are approximately defined, long-term funds domestically will also be more willing to hold long-term bonds, likely stabilizing or even lowering long-term interest rates. Chart 13: Milan's "Balance Sheet Guide" provides key details for liquidity system reform Source: "User Guide to Reducing the Federal Reserve's Balance Sheet," CICC Research Department A New Type of "Monetary-Fiscal Coordination" Based on the reforms outlined above, Waller has effectively achieved a new type of more subtle monetary coordination with fiscal policy. Unlike the relatively straightforward and administrative command-based methods employed by Trump to suppress the Federal Reserve's independence, demanding GSEs to purchase MBS and limiting credit card rates, Waller's monetary coordination is built upon rules and institutional frameworks. In terms of interest rate policy, based on the newly set inflation and economic data anchors, as well as considerations for long-term improvements in supply efficiency, the Federal Reserve can take into account a pause in interest rate hikes amidst geopolitical conflicts and inflation in related goods, while also contemplating further cuts once oil price issues are resolved. Regarding quantity policy, it has restricted excessive liquidity volatility while ensuring fiscal and financial institutions can still access funds marginally, in small, multiple, and smooth channels. The result anticipates that the Federal Reserve will continue to cooperate with fiscal policy and banks in expanding their balance sheets, alongside banks accelerating their own balance sheet expansions. Liquidity injection channels are expected to become more seamless and precise. In terms of financial regulation, increasing banks' balance sheet expansion capabilities through loosening regulations, while transferring banks' regulatory responsibilities to the Treasury. While achieving monetary-fiscal coordination, banks, under fiscal oversight, will expand their balance sheets, allowing them to act in concert with fiscal debt issuances as market makers, or channel funds into real industries through corresponding industrial policies. This effectively provides functional large fiscal initiatives with specific financial tools in support of the conceived transitions from virtual to real and the repatriation of manufacturing. Chart 14: Under the new framework, the Federal Reserve's passive cooperation with fiscal and banks financing demands is expected to trend toward balance sheet expansion, accelerating the expansion of banks' balance sheets. Note: The chart simplifies the balance sheet to reflect framework changes. Source: CICC Research Department CICC wishes to emphasize that even under the new framework, the Federal Reserve's role as "the last market maker" cannot be dismissed. Given the relationship between long-term bond yields and nominal economic growth trends, if this monetary coordination framework is implemented and short-term interest rates are lowered to stimulate the economy, long-term bond yields may conversely rise. In such a scenario, without direct interventions or indirect guarantees from the Federal Reserve, and reliant solely on banks and other private financial institutions to absorb U.S. Treasuries, it may prove challenging to effectively suppress long-term bond yields and avoid a stampede in times of risk. Thus, the Federal Reserve must still maintain its role as the last market maker. In fact, Waller himself opposes only the normalization of QE, not the initiation of QE in times of crisis to provide emergency liquidity to the market. Chart 15: The center of long-term bond yields follows the center of nominal growth Source: Bloomberg, CICC Research Department Chart 16: Private holdings struggling to avoid a stampede; the Federal Reserve's role as the last market maker remains difficult to relinquish. Note: Elasticity indicates the percentage decline in holdings for every 1 basis point rise in 10-year Treasury yields; negative values reflect reductions in Treasury holdings when yields rise. Source: FRED, CICC Research Department