The Federal Open Market Committee today announced nothing of substance. Its Fed funds target rate remains 5.25%%-5.50%. The balance sheet rolloff continues apace.
The media are sound-biting this as a “hawkish pause”, its absurd doublespeak for all talk and no action. In the context of the entire yield curve, Fed funds in this range is high. The Fed’s balance sheet meanwhile remains obese with MBS at a time when the Fed claims to be on a mission to control inflation, which the data say has bottomed out and is re-accelerating, both in lagging indicators like wages and in leading indicators like asset prices.
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.
“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 upshot is that the Fed erred by easing up on the brakes late last year. It should have maintained the 75 bp pace or accelerated the balance sheet rolloff. In the December minutes it noted the risk that markets would react bullishly but did it anyway, and asset price inflation took off again. This new inflationary impulse is now being registered in resurgent goods and services inflation. No mere Monday morning quarterbacking; we said so at the time. And then it compounded the error by failing to stem the asset price inflation once it was apparent.
So the Fed continues to add insult to injury. In fairness, there is no way to fully compensate for being too slow in responding to the 2020-2021 surge in inflation. Rates may yet reach 6% (ht jk). But had the Fed begun to renormalize in late 2020 – early 2021, it would not have had to hike even as high as it already has.
At a more general level, we also see a clear case of policy error … the same as the Fed committed in 2006-2008. The Fed behaves as if it tightens gradually enough, the economy and financial system will respond in kind. But they are nonlinear systems. It’s like adding snow to the top of a mountain slope one flake at a time. The snow doesn’t gradually ease down the slope, it builds up until it collapses in an avalanche.
The safer, saner approach is to agitate the system, deliver small shocks as the snow falls, so that small avalanches occur while the snow pack is small. The choice is not between avalanche or no avalanche, it’s between multiple small ones or one big one.
So the Fed and most of the financial media are missing the big issue. The combination of gradualism and telegraphing moves ahead of time is a systematically failed policy. It has before and will again result in the opposite, a large adjustment that is widely unexpected. There will be no “soft landing”. Inflation will build until it collapses precipitously in a deflationary crash.
Then, some time in 2024, the Fed will show us how fast it can act as it frantically slashes its rate target and prints trillions.