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The Fed Over Tightened, Again

If the Federal Reserve was a movie, it would have the most predictable plot, as they repeat the same mistakes over and over, in hopes of a different outcome. In December 2018, Fed Chair Jerome Powell announced an increase in the Federal Funds rate due to a strong economy. His move was met criticism by the Trump Administration, but Powell and the Fed held their ground, Three short months later, the Fed is pausing their plans to continue raising the Federal Funds rate and the Fed announced a plan to end their balance sheet unwind program later this year. If the economy is the best economy in the history of our country, why the sudden shift?

The Federal Reserve was designed primarily to control money-printing inflation, which was a problem in the early years of our country. Since, Congress has bestowed the Fed with creating full employment and price stability, which it does not have the tools or ability to do. The Fed does not concern itself with how many new dollars are being created, but how those dollars affect consumer prices.

When consumer prices start rising faster than the Fed wants, they tighten monetary policy by raising the Federal Funds rate and reducing the size of their balance sheet. The Fed monitors consumer prices on a monthly basis, but their data is lagged by approximately six months. Oddly their gauge for future currency-printing inflation is the unemployment data, even though the level of unemployment has little to do with inflation.

Unemployment, as tracked by the Bureau of Labor Statistic (BLS), is near its all-time lows and consumer prices are hovering around the Fed’s 2% target. Based the unemployment and consumer price data, the Fed surprised the world at their March press conference when they decided to hold off on further increases in the Federal Funds rate and they decided to stop their balance sheet unwind program.

When Chair Powell announced the Fed was not going to hike rates, this did not come as a surprise. The modern-day Fed rarely raises the Federal Funds rate more than three times a year, and rarely in the first quarter. The surprise was the end of the balance sheet unwind program, which Powell and his predecessors previously said was on autopilot and was akin to watching paint dry. Apparently, the paint is now dry.

Starting in May 2019, the Fed will reduce the amount of U.S. Treasury securities it is unwinding each month from $30 billion down to $15 billion. At the end of September 2019, the Fed will cease its balance sheet unwind of U.S. Treasury securities. In October 2019, the Fed will unwind up to $20 billion per month of Mortgage-Backed Securities (MBS) and reinvest the proceeds in U.S. Treasury securities of varying maturities, as the Fed moves towards its goal of having a balance sheet made up of entirely U.S. Treasury securities.

Some are citing the changes in Basel III, a voluntary framework on bank capital adequacy, stress testing and market liquidity risk as the reasons behind the Fed’s sudden change in heart. Prior to Basel III, all reserves in excess of the reserve requirement, regardless of source, are treated as excess reserves. Demand for reserves is increasing under Basel III and likely explains why large commercial banks are adding U.S. Treasury securities at a rapid pace, as banks now must hold reserves in proportion with their debts falling due within 30 days, rather than in proportion to their deposits as before.

It is entirely possible that the Fed has met with its largest member banks in the past three months, and based on the provisions of Basel III, came to an agreement on an adequate level of excess reserves based on the amount of debt coming due within a rolling 30-day period. Others say the Fed is bowing to the Trump Administration, which has been calling for an end to the balance sheet unwind, but that is unlikely given the political independence of the Fed. The more mainstream reason the Fed decided to back off has to do with the impending inversion of the 10-year, 3-month Treasury yield curve, which has since inverted.

An inverted yield curve occurs when short-term yields, such as the 3-month Treasury yield, are higher than long-term yields, or in this case, 10-year Treasury yields. Since banks borrow at short-term yields and lend at long-term yields, where they profit on the spread, an inverted yield curve tends to reduce bank lending. In a debt-based monetary system, such as ours, bank lending is critical to maintaining the growth rate of money supply.

While decelerations or contractions do not always lead to a recession, they often do. Since money is destroyed when a principal payment is made against a loan, in a zero- or low-interest rate environment, banks need to originate a large number of loans just to maintain the money supply. As it stands now, the three-month rate of change in the money supply is about to contract. There has not been a contraction in the yield curve since 2009 when the economy was in a recession, the Fed had the Federal Funds rate at zero percent, and the Fed was engaged in Quantitative Easing I.

When crude oil prices collapsed in the fourth-quarter 2018, it opened the door for the Fed to possibly pause their rate hiking cycle. Energy is a large component in the Consumer Price Index (CPI) and due to the lags in the CPI data, which are about six months in length, inflation in terms of the CPI is about to fall for the next three months. The Fed has been on record saying it expects the economy to pick up in the second quarter, which would start to reflect in their data by the second half of the year. In a sense, last year’s drop in crude oil is going to allow the Fed some breathing room.

The real issue is not the Basel III requirements or the inverted yield curve, even though both are factors, it is investors and speculators who led the Fed to overtighten monetary policy. The Fed claims to be data dependent, but they do look to Wall Street for clues as to when the Fed should make adjustments to monetary policy. When Wall Street indicates rates should be higher, the Fed takes this as a cue that higher rates are already factored into stock prices, so the Fed can hike rates without causing any collateral damage.

There are two ways Wall Street can signal the Fed to raise the Federal Funds rate. One way is through the futures market, where speculators can bet on the direction of the Federal Funds rate. When there is a consensus the Fed should raise rates, the Fed often does. The other way Wall Street can signal the Fed to hike is by pushing bond yields higher. By selling, or outright shorting U.S. Treasury securities, investors can drive yields higher.

As bond yields rise, the Fed begins to feel the pressure that they are behind the curve. To catch up to market expectations and inflation expectations, the Fed raises the Federal Funds rate. This relationship, at face value, seems to be a good one. Wall Street can gauge inflation in real time, while the Fed uses lagged government data. When Wall Street gives the ‘all clear’ signal, the Fed knows they can move without disrupting the markets, until the realization comes that Wall Street led the Fed off a cliff.

Due to the speculative nature of our stock market, investors can sell securities they do not own, which floods the market with supply. In the case of bonds, investors sell U.S. Treasury bonds they do not own, through short selling, and use the proceeds to buy risk assets or stocks. The act of short selling puts a large supply of bonds on the market, which artificially raises interest rates. If investors were unable to speculate on the U.S. Treasury bond market, then interest rates would not rise as high as they have during an expansionary cycle.

The Fed interprets rising interest rates as inflationary and does not concern itself with how or why interest rates are rising. Instead, the Fed simply responds to rising interest rates by raising the Federal Funds rate. It appears the Fed has gone too far.

Larry Kudlow, an American financial analyst and former television host serving as Director of the National Economic Council under the Trump Administration, has called for a -0.50% cut in the Federal Funds rate. President Trump has appointed Stephen Moore, an economic commentator and former campaign advisor to President Trump, to the Federal Open Market Committee (FOMC), whose appointment is subject to congressional approval. Moore is also calling for a -0.50% cut in the Federal Funds rate.

The Fed does not hold too much stake in an inverted yield curve, as they expect the economic expansion to resume, which will cause long-term yields to rise once again. The Trump Administration does not seem convinced the economy is going to grow, so they are calling for a reduction in the Federal Funds rate, which would push short-term yields back below long-term yields. While neither is likely to happen in the near term, Treasury yields continue to fall.

Speculators who shorted U.S. Treasury securities on the hopes for reflation are slowly realizing their dreams of reflation are turning into a disinflation nightmare. As disinflation takes hold of an economy, interest rates and Treasury yields fall.

Courtesy of Wall Street and bond speculators, it appears the Fed has once again found itself over the edge of a cliff and hung out to dry. Should economic growth continue to slow, and yields fall, the Fed will be forced to lower the Federal Funds rate. Rather than react now, the Fed will wait, as they always do, until they realize that once again, they have over tightened and sent the economy spiraling into a recession.

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