Why the Fed might be at ‘neutral’ already 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 criticising the US Federal Reserve than watching it. It’s easy to do. Anyone can play the game and attacking the Fed is like shooting at sitting ducks: officials at the central bank can’t respond directly given their public role.
Recently, Fed chair Jay Powell has been skewered by his critics for claiming that the federal funds rate was now at “neutral” at his July 27 press conference just after the policy-setting Federal Open Market Committee had voted unanimously to raise its benchmark federal funds rate range by 0.75 percentage points to 2.25 to 2.50 per cent.
His suggestion that the Fed is on the borderline of restrictive territory and therefore closer to being done tightening was well received by both bond and stock investors, but not by the Fed’s critics.
Former Federal Reserve Bank of New York president William Dudley said on Wednesday that, given the level of uncertainty, “I’d be a bit more sceptical” in saying policymakers had reached 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 delusion last year that inflation would be transitory. He accused Powell of saying things “that, to be blunt, were analytically indefensible”. He added, “There is no conceivable way that a 2.5 per cent interest rate, in an economy inflating like this, is anywhere near neutral.”
In fact, there is a conceivable way that Powell might be right after all. The Fed’s critics are ignoring that the central bank has been more hawkish in words and deeds than the European Central Bank and the Bank of Japan. Both of their official interest rates are still at or near zero.
As a result, the value of the dollar has soared by 10 per cent this year. In my opinion, that is equivalent to at least a 50-basis-point rise in the federal funds rate. Furthermore, the Fed has just started its quantitative tightening programme to unwind its massive asset purchases to support markets and the economy in recent years.
During June through August, the Fed will reduce its balance sheet by running off maturing securities, which will drop its holdings of Treasury securities by $30bn a month and its holdings of government agency debt and mortgage-backed securities by $17.5bn a month. So that’s a decline of $142.5bn over those first three months of QT.
Starting in September, the runoff will be set at $60bn for Treasury holdings and $35bn for agency debt and MBS. That’s $95bn a month, or $1.14tn through August 2023. There’s no amount set or termination date specified for QT.
In my opinion, QT is equivalent to at least a 0.50 percentage point increase in the federal funds rate too. Furthermore, in the December 2021 minutes of the FOMC, released on January 5 of this year, investors learned that “some participants” on the committee favoured getting out of the mortgage financing business entirely.
That would happen by swapping the Fed’s MBS for Treasuries in addition to letting them run off as they matured under QT. This would have further increased the supply of MBS for the market to absorb adding upward pressure on mortgage rates relative to Treasuries. No wonder that the 30-year mortgage rate jumped from 3.30 per cent at the start of this year to a high of 6.00 per cent on July 15, and 5.46 per cent currently.
I conclude that the peak 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 are equivalent to at least a 1 percentage point increase in the federal funds rate.
In addition, the extraordinary jump in both short-term and long-term interest rates in the fixed income markets has already accomplished much of the tightening for the Fed. In my opinion, the markets have already discounted a peak federal funds rate of 3 to 3.25 per cent — which is where it soon will be assuming that the Fed raises the rate by 0.75 percentage points again at the end of September as widely expected.
By the way, on October 1 2020, Dudley, when he was at the Fed, justified a second round of quantitative easing amounting to $500bn of securities purchases saying that it was equivalent to a 0.50 to 0.75 percentage point cut in the federal funds rate.
The Fed undoubtedly has some estimates from its in-house models on the equivalent rate rises represented by the strong dollar and QT. If so, they should share that information with the public.