Not one, but two, Fed officials are now publicly calling for more rate hikes. Stalwart hawk James Bullard and once uber-dove turned uber-hawk Neel Kashkari are calling for not one, but two, more rate hikes.
It’s not hard to sympathize. Progress on stemming consumer price inflation has flagged, and there are indicators it may be on the cusp of reaccelerating. Canary-in-the-inflation-mine stock prices suggest it already has. The S&P is knocking on a widely watched glass ceiling around 4200. If it convincingly breaks through, traders will take it as an all-clear and run with it. That this is happening while the market is supposedly on edge about the solidity of the banking system and a precarious debt ceiling contest only underscores that money is not as tight as five hundred basis points of rate hikes in barely a year would suggest. Dollar strength in the forex markets, another early indicator of progress on reining in final inflation, notably leading readings lower last year, is now notably MIA.
The Fed is courting policy error. Indeed, the Big Policy Error was in reckless years of ZIRP and QE culminating in the 2020-2021 grand finale, but I’ve been gravitating towards the popular-on-Wall-Street view that the Fed could be hiking rates too much. It’s just not because I think the Fed risks being too tight.
It feels funny saying this, because for years I’ve been arguing the Fed should use balance sheet ease to support increases in interest rates. This goes back well into the iTulip Finster’s Comments era, as ZIRP went on year after year, wreaking deep below-the-surface havoc on the economy.
So it has been gratifying to see the Fed finally following my advice. It’s just going overboard.
Exhibit A is the bent-out-of-shape yield curve. Exhibit B is bank runs. Banks are backed into a corner where they have to pay much, much more on deposits or watch them leave in search of greener pastures.
So how is monetary policy still too easy? Rate policy is being asked to do all the heavy lifting. The balance sheet has been relegated to asterisk status.
But isn’t the balance sheet shrinking? Sure, but as we’ve noted before, it’s only smaller compared to a year or so ago. Compared to its longer run trend, it’s still massive. Trillions larger than at the beginning of 2020. The hangover of the subsequent moneypalooza is still feeding inflation, both in asset prices and consumer prices.
But isn’t the Treasury market already in a supply surplus? Possibly, but there’s more than one way to trim a bloated balance sheet. Especially one obese with mortgage securities that had no business being there is the first place.
i think the fed [along with the markets, the economy, and all of us] is trapped either way. raising rates will just move the bank WALK [as jim bianco calls it] into a bank TROT, and kill community and regional banks even faster and more broadly than is currently the case. this has got to lead to a significant credit crunch, albeit it will take time to unfold.
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otoh, if they rely more heavily on shrinking the fed’s balance sheet, the market’s capacity to absorb treasury paper will be even more inadequate than expected when the ceiling dance concludes and the treasury refills the tga along with resuming financing issuance.
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either way rates go up a lot, though the shape of the yield curve might be somewhat different depending on the selection of tenors for treasury issuance in the second scenario.
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do you think it makes a difference, bill? either way, a recession will increase the deficit further and necessitate even more issuance.
The last thing this beleaguered Treasury market needs is a discretionary increase in supply. I think that was the gist of the last paragraph … leave the Treasury trimming where it is and step up the rolloff of other assets instead.
Even after the debt ceiling is inevitably raised, Treasury supply itself is likely to surge as it replenishes its Treasury General Account cash cushion, as you point out.
The matter of how to weigh the massive longer term expansion of the balance sheet versus the more recent contraction is an open question. The best I can do is look to the financial markets for continuing feedback. If stocks continue skyward, more tightening is indicated. If they take another 20%+ header, it’s probably time to back off.
Regardless, no question the Fed is in a tight spot. There is no pain free exit from years of ZIRP and QE. The menu only has entries as to how the discomfort is distributed. Powell has repeatedly emphasized sparing average Americans struggling under the burden of price inflation. FWIW I agree with this prioritization. Wall Street has been living large for years. And if it came down to a choice between banks failing and ordinary people failing, let the banks go.
That’s admittedly an oversimplification though. Clearly a shaky banking system doesn’t benefit anyone, and the Fed has ways of more surgically dealing with specific banking problems. Nevertheless my view is that arguments that any particular difficulty justifies abandoning the inflation fight bear a much heavier burden of proof than is typically asked of them.