The Federal Reserve seems increasingly comfortable with its current “tightening” mode.
The signal for the summer is that the Fed will raise its policy rate range by 50 basis points in both in June and July.
This would bring the top of the political range to 2.00%.
How far will Fed officials go is another question?
Some analysts believe that a good estimate is somewhere between 2.00 and 3.00%.
Yet others think the rate will go as high as 6.5%.
Some analysts even think it’s not even high enough.
Of course, the problem is that no one really knows where the policy rate should peak.
Fed Chairman Jerome Powell, being very honest, said on Tuesday,
“Officials don’t know with ‘no confidence’ where the neutral is.”
The process as it currently stands is as follows.
The Federal Reserve will choose a target range for the federal funds rate and then see what it takes to keep the rate within that range.
If inflation does not appear to be receding to this level, then the Fed will need to reassess the situation and perhaps move the range up.
This iterative process could continue for some time. The Fed just doesn’t want to fall any further behind the “catch up” process it now feels itself in.
The Federal Reserve is now in a new policy mode.
Beginning in April 2020, the Federal Reserve focused on balance sheet and market liquidity.
At that time, the Federal Reserve pledged to purchase, outright, $120.0 billion of securities each month.
The concern was that the banking system and financial markets faced such a significant threat from the spread of the covid-19 pandemic and the economic recession that the Fed needed to do everything it could to ensure that there was enough liquidity in the system to prevent a major disaster from occurring.
Thus, the main objective of monetary policy was the monthly purchases of securities.
But, there was a side story that Federal Reserve officials were watching.
Federal Reserve officials did not want the effective federal funds rate to fall below zero.
The Fed has primarily used reverse repurchase agreements to maintain the positive stance of the fed funds rate.
Throughout 2020 and into 2021, so much liquidity has been injected into the banking system that the use of reverse repurchase agreements has increased. By the end of 2021, the volume of repos on the Fed’s balance sheet was approaching $2 trillion.
But, by the end of 2021, the threat of inflation was forming, and Federal Reserve officials began to “cut” its monthly purchases.
In September 2021, the Fed locked in the effective federal funds rate at 0.08% and held that rate until March 2022, when it oversaw the increase in the effective federal funds rate to 0.33%.
The Fed’s monetary policy was changing.
The Fed now sets the key interest rate and then manipulates its balance sheet to keep the fed funds rate on target.
It seems that this will be the political procedure in the near future.
On May 5, the effective federal funds rate rose to 0.83%.
Balance sheet movements
Since March 16, 2022, when the Fed made its first rate change this year, the Federal Reserve has added only about $14.0 billion of directly purchased securities to its portfolio.
But reserve balances with Federal Reserve Banks, an indicator of excess reserves in the commercial banking system, fell by about $600.0 billion.
The apparent necessity for this decline in reserve balances is that it put pressure on the commercial banking system to increase the effective federal funds rate.
And, I would say that’s the kind of balance sheet behavior that we’re going to see as we head for more Fed monetary policy tightening.
First, the Fed will increase the range of the key interest rate.
Second, the Fed will adjust its balance sheet so that reserve balances with the Federal Reserve Banks decrease, supporting the hike that the Fed has just made in its key interest rate.
How, exactly, the Fed will resolve this is unknown at this time.
My guess is that the Fed will reduce its balance sheet over time by combining maturing securities off the Fed’s balance sheet and reducing the amount of reverse repurchase agreements that are still on the balance sheet.
This will be a practical matter as far as the Fed is concerned and the amounts will be determined by the maturity composition of the Fed’s securities portfolio and the ability to reduce reverse repos.
Thus, the Fed will continuously monitor changes that occur on the Fed’s balance sheet.
It will not be an easy task.
There can be a lot of bumps along the way.
For example, what will the Fed do if there is a significant drop in stock prices?
Additionally, there appear to be many sectors of the economy experiencing dislocations and other imbalances that could cause difficulty in achieving a “soft” landing.
We just read this morning about the weaknesses being felt in the subprime lending space.
Then there are other areas that I have just written about recently, such as the problems encountered in special purpose acquisition companies, SPACs.
The Fed’s financial largesse over the past two years has led to the discovery of many areas of the market where potential problems have been uncovered.
What will the Federal Reserve do if something seems to be falling apart in these areas?
So next year will not be easy.
Many fear that Mr. Powell and his colleagues at the Fed are doing what they have done in the past, which is to err on the side of monetary stimulus to avoid any “surprise” disruption.
Mr. Powell is talking very loudly right now. In general, it seems that the position he takes is appreciated by the investment community.
We’ll see what happens when the real pressure is applied.