Why the Fed might already be “neutral” 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 criticizing the US Federal Reserve than watching it. It is easy to do. Anyone can play along and attack the Fed is like shooting sitting ducks: central bank officials cannot respond directly given their public role.

Recently, Fed Chairman Jay Powell was annoyed by critics for claiming the federal funds rate was now “neutral” during his July 27 press conference just after the Federal Open Committee market had voted unanimously to increase its benchmark federal funds. rate range of 0.75 percentage point to 2.25 to 2.50 percent.

His suggestion that the Fed is on the edge of restrictive territory and therefore closer to the end of tightening was welcomed by bond and equity investors, but not by Fed critics.

Former New York Federal Reserve Chairman William Dudley said Wednesday that, given the level of uncertainty, “I would be a little more skeptical” that policymakers had achieved neutrality.

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 “which, to be frank, were analytically indefensible”. He added: “There is no conceivable way that a 2.5% interest rate, in a swelling economy like this, is anywhere near neutral.”

In fact, there is a conceivable way that Powell is right after all. Fed critics ignore that the central bank has been more hawkish in word and deed 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 climbed 10% this year. In my view, this is equivalent to at least a 50 basis point hike in the fed funds rate. In addition, the Fed has just launched its quantitative tightening program to unwind its massive asset purchases to support the markets and the economy in recent years.

From June to August, the Fed will reduce its balance sheet by eliminating maturing securities, which will reduce its holdings of Treasury securities by $30 billion per month and its holdings of government agency debt and asset-backed securities. mortgages of $17.5 billion per month. So that’s a drop of $142.5 billion in those first three months of QT.

From September, the run-off will be set at $60 billion for Treasury holdings and $35 billion for agency debt and MBS. That’s $95 billion per month, or $1.14 billion through August 2023. There’s no set amount or specified termination date for QT.

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In my opinion, QT is also equivalent to an increase of at least 0.50 percentage points in the federal funds rate. Additionally, in the FOMC’s December 2021 Minutes, released on January 5 this year, investors learned that “some participants” on the committee favored a full exit from the mortgage finance industry.

This would happen by swapping Fed MBS for Treasuries in addition to letting them flow as they matured under QT. This would have further increased the supply of MBS so that the market could absorb upward pressure on mortgage rates relative to Treasuries. No wonder the 30-year mortgage rate jumped from 3.30% at the start of this year to a high of 6.00% on July 15 and 5.46% currently.

I conclude that the peak in the fed funds rate during the current monetary tightening cycle will be lower than otherwise because the combination of the QT and the strong dollar equates to at least a 1 percentage point increase in the fed funds rate .

In addition, the extraordinary rise in short and long-term interest rates in fixed income markets has already contributed much of the tightening for the Fed. In my view, the markets have already discounted a maximum federal funds rate of 3 to 3.25% – this is where he will soon assume that the Fed will raise the rate again by 0.75 percentage points at the end of September, as widely expected.

Incidentally, on October 1, 2020, Dudley, when he was at the Fed, justified a second round of quantitative easing amounting to $500 billion in securities purchases by saying that it amounted to a 0.50 to 0.75 percentage point cut in the federal funds rate.

The Fed no doubt has estimates from its internal models of the equivalent rate hikes represented by the strong dollar and the QT. If so, they should share this information with the public.

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