L’AGEFI - The Fed and the markets can both be right!

Translation of an article published by L'AGEFI on 13 September 2023
By Michala MARCUSSEN, Group Chief Economist

Chair Powell has consistently delivered the clear message that even though inflation is easing, the Federal Open Market Committee (FOMC) stands prepared to hike rates further if deemed necessary and, in any case, intends to hold policy at restrictive levels until inflation is on a clear path back to target. Market implied rate expectations, however, sees the FOMC delivering several rate cuts in 2024, and with this process starting early in the year. This market view coexists, moreover, with a consensus that sees only a gradual decline of core PCE inflation, from the latest reading of 4.2% in July to around 3% come spring, still well in excess of levels consistent with the 2% inflation target.

Question is, can the FOMC deliver on its intention and markets still be right. The answer may well reside with the ongoing shrinkage of the Federal Reserve’s large balance sheet or so-called quantitative tightening (QT), and the first clue on this option is found in the minutes of the FOMC’s 25-26 July where “A number of participants noted that balance sheet runoff need not end when the Committee eventually begins to reduce the target range for the federal funds rate”. 

Recent Fed commentary provides further evidence. As a recent example, Dallas Fed President Lorie Logan, commenting on the balance sheet, noted that “if we are lowering interest rates to get back to a neutral position, that wouldn’t be a reason to stop the decline”. There is today likely ample room for rate cuts, even with only a gradual decline in inflation, before the Fed hits a neutral stance.

QT influences financial conditions through several channels, but central to the possibility of the Fed being able to cut rates, while still keeping policy at restrictive levels, is its impact on bond yields. Analytically, Treasury bond yields can be divided into two components: an expected future rate path and a term premium. The QT effect that the Fed would be seeking in steering the fed funds target rate back to neutral while avoiding any unwarranted easing of financial conditions is found primarily on the term premium.

At present, the FOMC’s QT policy allows up to $60bn of US Treasury holdings and $35bn of agency debt and agency mortgage-back securities holdings to expire each month. In contrast to quantitative easing, when the Fed was purchasing longer-date assets and actively seeking to compress term premia, the present QT can be considered “passive” in that it merely allows the shortest-dated assets to expire and entails no “active” selling of longer-dated asset. The impact on the Treasury yield curve’s term premia as such comes rather from government’s financing needs and the related debt issuance strategy. The greater these financing needs and the longer the duration of the related issuance, the greater the upward pressure on the term premia all else being equal.

It’s no secret that the US Treasury has very large financing needs and Fitch Ratings’ decision to downgrade the US from AAA to AA+ back in early August was indeed motivated by “a high and growing general government debt burden”. And while market term-premium are not directly observable and must be estimated, there is good evidence that these saw some increase over the summer reflecting the prospect of the US Treasuries large upcoming issuance.

Set in the context of a longer history, however, term premia arguably remain low, and it would be fair for the Fed to argue that in pursing “passive” QT it is merely returning its very large balance sheet and its impact on term premia to a more neutral position. This has the further advantage also of allowing the Fed to build up ammunition should future circumstances require new QE.

The final twist in the Fed’s balance sheet considerations stems from banking sectors liquidity needs. As the Fed pursues QT, liquidity should tighten further, and the risk is to see new pressures emerge. The Fed already demonstrated its willingness to step in and ease tensions with the turmoil in US regional banks earlier this year and its communication clearly distinguished these measures from policy tightening, a point that was well understood by markets at that time.

As the current monetary policy cycles enters a new phase, Fed communication on steering with multiple tools may indeed become more challenging, but the bottom line is that the Fed’s commitment to holding policy restrictive for a longer period and market expectations for rate cuts can both be right.