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Keep an eye on the Fed's accelerating asset sales

U.S. Federal Reserve Chair Janet Yellen attends a conference of central bankers hosted by the Bank of France in Paris, Nov. 7, 2014.
Charles Platiau | Reuters
U.S. Federal Reserve Chair Janet Yellen attends a conference of central bankers hosted by the Bank of France in Paris, Nov. 7, 2014.

The U.S. monetary authorities (Fed) are stepping up the contraction of their balance sheet at a surprisingly fast pace. Since peaking at $4.07 trillion last August, the Fed's monetary base has been reduced by $259.2 billion as of the latest reserve reporting date on November 26, 2014.

More than half of these Fed asset sales occurred between the end of October and the end of November. But the balance sheet remains an impressive $3.8 trillion -- a huge difference with the pre-crisis monetary base of $820-$830 billion. It is interesting to note that even at these comparatively modest amounts of high-powered money, the pre-crisis U.S. monetary policy was very expansionary: the federal funds rate was fluctuating around 3 percent while the inflation rate was accelerating above 4 percent.

Read MoreThe Federal Reserve is making a major shift in interest rate policy

Obviously, these are different times now: the U.S. financial system and the economy have changed in a rapidly evolving global context. Still, the comparison is useful because it shows how much the Fed's balance sheet will have to adjust in the months ahead.

Excess reserves keep federal funds rate down

One key aspect of that adjustment process is the Fed's statement that interest rates will remain low well after the beginning of large liquidity withdrawals to "normalize" the policy stance.

The question is: how is that possible? If the quantity of money is being reduced in as large amounts as is currently the case, would it not be normal to expect that its price (i.e., interest rate) would also have to rise?

Certainly it would. But what makes the Fed's statement credible is the fact that huge excess reserves (money banks can use to make loans) of the U.S. banking system -- $2.4 trillion at the last count – will continue to keep an extraordinarily liquid interbank market for some time. Last Friday, for example, the effective federal funds rate (overnight money banks lend to each other) closed trading at 0.11 percent – more than half way below the Fed's target of 0.25 percent.

These excess reserves are now being drained by the Fed's bond sales; they have been cut by $286.1 billion from their peak of last August. There is still plenty of cutting to do, though. Just think that during the pre-crisis period from January 2007 to June 2008 banks' average excess reserves were fluctuating around monthly levels of $1.9 billion (sic). That is a far cry from the $2.4 trillion we have now.

Here, then, is the answer: the highly liquid interbank market will allow the Fed to manage the federal funds rate within its target range of 0-0.25 percent in the months ahead.

Will that be until the middle of next year, or until late 2015?

These are wild guesses of some Fed officials playing the "forward guidance" games.

Read MoreFed completes the taper

A much more useful idea is that – as any short-term forecaster – the Fed will be reacting to data rather than to any specific dates.

And, as always, the policy relevant data will be inflation expectations driven by current and expected output and labor market conditions.

That brings us back to the hard part: estimating the impact of factors underpinning aggregate demand and employment creation.

Growth looks good, but inflation doesn't

Jobs and incomes are always a good starting point because, along with credit costs, they determine the outlook for more than three-quarters of the U.S. economy.

Labor market numbers for November were good. The only concern I have is that we seem to be running up against some structural hurdles that may limit further gains in employment growth.

For example, the labor supply has been roughly unchanged for most of this year. The long-term unemployed (people out of work for 27 weeks or more) are still nearly one-third of the total jobless numbers. Adding the people working part-time because they cannot find a full-time job and those who have apparently given up on job search, we get a real unemployment rate that is exactly double the reported rate of 5.8 percent.

This is an enormously important question mark. If we are at the limits of labor supply, or if we have a serious mismatch between the labor on offer and the labor demanded, the result will be an increase in the price of labor (wage and non-wage labor costs). And that, in turn, will drive up inflation because rising labor costs are difficult to offset by productivity gains in the short-run.

I have raised this caution flag in earlier columns. The flag is still up and fluttering.

Personal incomes after tax and corrected for inflation have risen 2.3 percent in the first nine months of this year -- a big improvement from a 0.4 percent gain during the same interval of 2013. The personal savings rate (personal savings as a percentage of disposable income) at 5 percent is near recent record-high numbers, indicating some strengthening of households' spending power.

And there is the outlook: employment gains, modestly rising personal incomes, a historically high personal savings rate and low credit costs are likely to sustain the present growth dynamics of the U.S. economy in the months ahead.

Read MoreFed now expected to stay lower for a lot longer

And here is a rider: I don't think that a growth rate at or above the current 2.3 percent can continue without rising cost and price pressures. Slowing supplier deliveries, growing order backlogs and accelerating price increases reported in the November surveys of the Institute of Supply Management (ISM) strongly suggest an economy hitting its physical limits to growth.

Investment thoughts

The Fed is rapidly shrinking its balance sheet. Assets are being sold for cash to withdraw excess liquidity.

Technically, the Fed can keep the federal funds rate within its current 0-0.25 percent range for some time because of large excess reserves in the interbank market.

But the Fed has to work fast to destroy the inflationary potential of excess liquidity before the actual inflation begins to edge up.

Equities are still my preferred asset class -- provided the portfolios are carefully reviewed toward a defensive posture. Also, think of putting some of that yellow stuff under your Christmas tree.

Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.