Steve Barrow, Head of Standard Bank G10 Strategy thinks that recession risks are still quite low, and one reason for this is that the Fed tightening some think will tip the economy over the recessionary edge is not as biting as generally perceived.

To explain this, he will make use of an embarrassingly simple analogy to show why monetary conditions are not as tight as many might think. Just suppose that you are a farmer. Not just any old farmer, but a farmer with a monopoly over the supply of apples. You control the supply of apples across the country and imports of apples are disallowed. In this position, you can target the price or the quantity of apples but not both. If you target the price at a certain level, then you adjust the supply of apples so that it equates to demand at this particular price level.

In other words, the price is set and the quantity is variable. Alternatively, you might want to set a quantity of apples that you are willing to supply. In this case, the quantity is fixed, but the price fluctuates until the demand for apples equates to the amount of apples that you are prepared to supply. But while you can only control price or quantity, there will still be an impact on the other when one is adjusted.

For instance, if you set the price but then decide to hike the price, it is very likely that demand for apples will go down and hence the amount of apples you supply will go down. Alternatively, if you set the quantity of apples supplied but then decide to reduce that quantity it is likely that there will be excess demand for apples at the original price, and the price will rise until demand equates to the new (lower) level of supply. So, why are we talking about apples?

It is an easier way to understand how central banks (which are monopoly suppliers of currency) operate. In the dim and distant past some, such as the Federal Reserve targeted the supply of reserves to the banking system (or apples in Steve Barrow’s  analogy) and allowed the price of these apples (the fed funds rate) to fluctuate so that the level of reserves met the Fed’s target. But this was way back in the late 1970s. These days, central banks’ target price (the policy rate), not quantity (reserves). But, as we’ve already said, if the price is lifted, we should expect the quantity supplied to fall.

In other words, as the Fed hikes rates, it is likely that the amount of reserves in the banking system will fall. In the simplest of terms, this is because higher policy rates reduce the demand for loans from the non-bank sector and banks will be able to hold fewer reserves as a result. But if something strange happens, like a rise in reserves, it might mean that the central bank’s policy is not as effective as it might anticipate. And that’s what has been happening in the US. For while much of the focus in the market has been on the Fed’s quantitative tightening as it reduces its bond holdings, the amount of reserves in the banking system has stayed more stable.

For instance, the factors supplying reserves to the banking system have fallen by close to USD1tr over the past year, mainly because the Fed’s bond holdings have been cut by USD800bn. But the factors draining reserves from the banking system, such as reverse repos, have fallen by a similar amount at just over USD1tr.

In short, reserves are about the same as they were a year ago. Or, to go back to Steve Barrow’s analogy, it is as if the price of apples has gone up (the fed funds rate) but the supply (and demand) of apples is about the same. The country is enjoying the same consumption of apples, but at a higher price. The danger for an economy when this story applies to policy rates and reserves is that rate hikes that are accompanied by rising (or in this case static) reserves may not bear down on demand sufficiently and hence may not produce the desired reduction in inflation over the long haul, even if it does help to avoid a recession.

“It may also mean that this surplus of liquidity finds its way into assets if loan demand from the non-bank sector is stymied by higher policy rates, and that might be one reason why asset prices have stayed quite robust even as the Fed has hiked,” said Steve Barrow.