Because the Fed may already be “neutral” on monetary policy

The writer is president of Yardeni Research and author of Fed Watching for Fun & Profit

Most Fed watchers seem to spend more time criticizing the US Federal Reserve than watching it. It’s easy to do. Anyone can play and attack the Fed is like shooting sitting ducks: central bank officials cannot respond directly given their public role.

Recently, Fed Chairman Jay Powell was overwhelmed by his critics for claiming that the federal funds rate was now “neutral” at his July 27 press conference immediately after the Federal Open Market Committee voted unanimously to increase its Federal Funds benchmark rate range from 0.75 percentage points to 2.25 to 2.50 percent.

His suggestion that the Fed is on the edge of restrictive territory and therefore closer to the end of the tightening was well received by both bond and equity investors, but not by Fed critics.

Former Federal Reserve Bank of New York president William Dudley said Wednesday that, given the level of uncertainty, “I would be a little more skeptical” that politicians have gone neutral.

Two days later, former Treasury Secretary Lawrence Summers was more critical. He accused Powell of engaging in “wishful thinking” similar to the Fed’s illusion last year that inflation would be transient. He accused Powell of saying things “which, to be blunt, were analytically indefensible”. He added: “There is no conceivable way that an interest rate of 2.5 percent in a bloated economy like this is nearly neutral.”

Indeed, there is a conceivable way Powell might be right after all. Fed critics are ignoring that the central bank has been more aggressive in word and deed than the European Central Bank and the Bank of Japan. Both of their official interest rates are still zero or close to zero.

As a result, the dollar’s value has risen 10 percent this year. In my view, this equates to an increase of at least 50 basis points in the federal funds rate. Furthermore, the Fed has just begun its quantitative tightening program to ease its massive asset purchases in support of markets and the economy in recent years.

From June to August, the Fed will reduce its balance sheet by eliminating maturing bonds, which will reduce its holdings in Treasury by $ 30 billion per month and its holdings in governmental and mortgage-backed debt by $ 17.5 billion per month. So that’s a $ 142.5 billion drop in those first three months of QT.

Starting in September, the runoff will be set at $ 60 billion for Treasury holdings and $ 35 billion for agency and MBS debt. This is $ 95 billion per month, or $ 1.14 trillion through August 2023. No amount or due date specified for QT has been set.

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In my opinion, QT equates to an increase of at least 0.50 percentage points in the federal funds rate as well. Additionally, in the December 2021 FOMC minutes, released on January 5 this year, investors learned that “some participants” of the committee were in favor of exiting the mortgage financing business entirely.

This would happen by trading the Fed’s MBS for Treasuries as well as letting them slip away as they mature below QT. This would have further increased the supply of MBS to be absorbed by the market, adding upward pressure on mortgage rates relative to Treasuries. No wonder the 30-year mortgage rate jumped from 3.30 percent earlier this year to a high of 6.00 percent on July 15 and to 5.46 percent now.

I conclude that the spike in the federal funds rate during the current monetary tightening cycle will be lower than otherwise, because the combination of QT and the strong dollar equates to an increase of at least 1 percentage point in the federal funds rate.

Furthermore, the extraordinary jump in both short and long-term interest rates in fixed income markets has already completed much of the tightening for the Fed. In my view, the markets have already discounted a maximum rate on federal funds. 3 to 3.25%, which is where it will soon assume the Fed will raise the rate by 0.75 percentage points again at the end of September, as widely expected.

Speaking of which, on October 1, 2020, Dudley, when he was at the Fed, justified a second round of quantitative easing in the amount of $ 500 billion worth of stock purchases by saying it amounted to a 0.50 to 0.75 percentage point cut. Federal Funds Rate.

The Fed undoubtedly has estimates from its internal models of equivalent rate hikes represented by the strong dollar and QT. If so, they should share that information with the public.

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