The Federal Open Market Committee today announced a 25 bp hike in its Fed funds target rate to 5.25%%-5.50%. The balance sheet rolloff continues apace.
In the context of the entire yield curve, Fed funds in this range is high. The Fed’s balance sheet meanwhile remains far out of whack with historical trends, leaving monetary policy in accommodative mode, as discussed more fully in Fed Preview. It’s hard to anticipate where this experiment in unbalanced policy will lead. For the time being, while trailing indicators of inflation like consumer prices are moderating, leading indicators like asset prices show a new wave of inflation entering the pipeline.
Maybe some patience is in order. The balance sheet is being trimmed, albeit at a pace that still leaves it massively larger than before the explosive expansion of 2020. At what point does it catch up sufficiently to actually provide the restrictive character Fed PR suggests? I don’t know, but would look for the balance sheet to return to somewhere in the neighborhood of its pre-2020 trend. We will know for sure when asset prices take another leg down. If the Fed is as serious about nipping inflation in the bud as it portrays, it should accelerate the runoff of non-treasury assets such as MBS.
So it appears that despite the Fed demur, and the media monomania over rate policy, the balance sheet is where policy is at. Interest rate policy has lost a lot of its punch due to the payment of interest on reserves. For most of history, raising the Fed funds target was done by restricting money … a rising rate was effect, not cause. In the QE era there is abundant money; the Fed has to actually pay interest on reserves to support its rate target from below. It creates the money to do so, so this program is expansionary.
This is only offset if the Fed is shrinking its balance sheet by other means. But the net effect is that a given increase in the Fed funds target is much less than it would appear based on history. This explains the unimpressive effect of what has been billed as one of the most aggressive hiking campaigns ever.
So even as the lagging effects of the last monetary expansion are being worked off, asset prices say a new impulse is in progress. Despite the Fed’s tough talk, money is not yet tight.
As to why we can only speculate. It may be that the Fed is unable or unwilling to resist pressure from Wall Street to keep money easy. One clue is that after repeatedly emphasizing the importance of tightening financial conditions last year, it has gone quiet on the subject since last December. The meeting minutes note concern that stepping down the size of hikes from 75 to 50 bp might reignite asset price inflation. That’s just what happened, but the Fed seems no longer concerned.
Long and variable lags has become the market mantra. This is a transparently disingenuous plea for easier money. If it were an objective, neutral concern, where was it when the Fed was printing by the trillions and promising ZIRP forever? AWOL. Not a peep of caution, even after inflation had begun to filter into consumer prices. It’s so simple a child could do it. Watch the data that don’t lag. Real time markets respond instantaneously. When the Fed hit Print on March 23, 2020, the dollar tanked and real time prices soared. Lag: 0.
The Fed takes months, quarters and years to tighten. But it can ease in a New York Fed minute. Forget all the rhetoric about fighting inflation. The Fed is an inflation creation machine.
The arsonist posing as the fire brigade.
Forget the 1970s Whip Inflation Now slogan. Here in the 2020s, it’s Whip Inflation Tomorrow!