The Fed's monetary policy has lost some of its potency and interest rates may need to rise much higher as a result, economist says
A Wall Street economist says the Federal Reserve is losing its power to influence the U.S. economy.
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A Wall Street economist says the Federal Reserve is losing its power to influence the U.S. economy.
If he’s right, then it means the central bank will likely need to hike interest rates much higher than it otherwise would have, potentially sparking another selloff in stocks and bonds.
In a note shared with clients last week, Nomura Research Institute Chief Economist Richard Koo challenged the notion that the U.S. economy’s resilience in the face of the Fed’s most aggressive interest-rate hikes in four decades is partly the result of the lagged effects of monetary policy that Federal Reserve Chairman Jerome Powell cited once again during his speech from Jackson Hole on Friday.
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While inflation has fallen since the summer of 2022, the U.S. economy has remained surprisingly resilient. According to Koo, this isn’t an accident, but a symptom of how the Fed’s pre-pandemic era policies have permanently changed the U.S. financial system.
He argued that an explosion of bank reserves built up during the era of easy money has helped to insulate the financial system from the effects of the Fed’s policies which have “lost some of [their] potency” as a result. Reserve balances have exploded since the collapse of Lehman Brothers in September 2008, according to weekly data from the Federal Reserve.
Here’s how Koo described this dynamic in his note.
“Central bank monetary policy ordinarily relies on two tools: interest rate control and the supply of liquidity. As I have noted previously in this report, then-Fed Chairman Paul Volcker’s effort to stamp out inflation starting in October 1979 succeeded because he restrained the supply of liquidity.”
“U.S. banks had almost no excess reserves at the time, and when the Volcker Fed reduced the supply of those reserves, they rushed en masse to secure reserves. This sent the federal funds rate soaring to 22%, weakening the economy and stabilizing inflation.”
“Today, however, the prolonged application of QE has left the US with excess reserves of some $3 trillion, or 1,600 times the amount that existed prior to Lehman Brothers’ failure.”
“This means the Fed no longer has the option of tightening by reducing the supply of liquidity. The only way to tighten policy is to raise interest rates.”
Data from the Federal Reserve Bank of St. Louis showed bank reserves parked at Fed branches stood at just under $3.2 trillion as of Aug. 23. New data are released weekly. By comparison, reserves amounted to $5.7 billion in December 2007.
According to Koo, the upshot of this is that if the Fed wants to materially slow the U.S. economy to drive inflation back to its 2% target, then interest rates will need to be raised high enough that borrowers balk.
“Under such circumstances, the monetary authorities cannot expect tightening to work unless they discourage borrowers by raising rates far higher than they normally would,” Koo said.
Koo, based in Tokyo, has studied balance-sheet recessions in the wake of the 2008 financial crisis and before joining Nomura, worked at the New York Federal Reserve earlier in his career.
Campbell Harvey, a Duke University finance professor best known for developing the yield-curve recession indicator, says the Federal Reserve’s read on inflation is out of whack. And, as a result, the likelihood that the U.S. slips into a recession is increasing.
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“The [inflation gauge] that the Fed uses makes no sense whatsoever, and it’s totally disconnected from market conditions,” Harvey told MarketWatch in a phone interview.
The Fed’s measures of inflation are heavily weighted toward shelter costs, which reflect the rising price of rental and owner-occupied housing. For example, shelter inflation has been running at 7.3% over the past 12 months, and also as of the most recent consumer-price index, for August. Shelter represents around 40% of the core CPI reading.
Harvey says that’s a problem because shelter’s retreat loosely follows the broader trend lower for headline inflation but at a lag, and the Fed wouldn’t be properly accounting for that lag if it decided to keep its target interest rates restrictively high.
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The Canadian-born Duke professor says that the Fed risks driving the U.S. economy into recession because it has achieved its goal of taming inflation, which peaked at around 9% in 2022, and isn’t making it clear that its rate-hike cycle is complete.
“Now, the higher those rates go, the worse [the recession] is,” he said.
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A looming government shutdown could prevent the Federal Reserve from raising rates in November, but not for the reason you might think, according to Bank of America.
Not only would the shutdown potentially slow down the economy and make a rate hike the wrong move, but a long impasse would mean central bank policymakers have only limited access to inflation data, the investment bank noted. That's because unfunded agencies such as the departments of Labor and Commerce wouldn't be producing key data reports on price trends.
"If the shutdown lasts for a month or more, the Fed would essentially be flying blind at its November meeting, having learned very little about economic activity and price pressures since the September meeting," Bank of America U.S. economist Aditya Bhave said in a note.
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A looming government shutdown could prevent the Federal Reserve from raising rates in November, but not for the reason you might think, according to Bank of America.
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The JPM CEO warned that rates may need to rise further to fight inflation, highlighting the fact that the difference between 5% and 7% would be more painful for the economy than going from 3% to 5% was....Jamie Dimon said:"First of all, interest rates went to zero. Going from zero to 2% was almost no increase.
Going from zero to 5% caught some people off guard, but no one would have taken 5% out of the realm of possibility.
I am not sure if the world is prepared for 7%.
I ask people in business, 'are you prepared for something like 7%?' The worst case is 7% with stagflation.
If they are going to have lower volumes and higher rates, there will be stress in the system.
We urge our clients to be prepared for that kind of stress.
Warren Buffett says you find out who is swimming naked when the tide goes out. That will be the tide going out.
These 200bps will be more painful than the 3% to 5%."
Minneapolis Federal Reserve President Neel Kashkari said Wednesday he's unsure whether the central bank has raised interest rates enough to tame inflation.
Speaking one day after he penned an essay suggesting that rates may have to go "meaningfully higher" from here in order to bring down prices, Kashkari told CNBC that the neutral rate of interest, or one that is neither holding back the economy nor stimulating it, may have moved higher.
"I don't know," he said on "Squawk Box" when asked whether the current target range for the federal funds rate of 5.25%-5.5% is "sufficiently restrictive" to bring inflation back to the Fed's 2% goal. "It's possible given the dynamics or the reopening of the economy, that the neutral rate may have moved up."
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Against most market odds, the Federal Reserve can still surprise investors with an additional rate hike in November, with a higher-for-longer narrative yet to filter through the macro environment, said Pat LaVecchia, CEO of Oasis Pro.
At the September meeting, the Fed followed through on a hawkish pause, promising higher for longer interest rates as economic growth continued to be stronger than expected. This is why the tightening cycle might not be over, LaVecchia told Kitco News.
"The next rate hike will occur, even though the statistics suggest it won't. I do think it'll be November," LaVecchia said on the sidelines of the Mainnet Conference, which took place in New York City between September 20-22. "And then 2024 will be a steady state."
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That they weren't all along, is testament to how short sighted they are.Markets are currently looking like folks are now expecting another hike.
That they weren't all along, is testament to how short sighted they are.
Has it ever not been?Taking liquidity out of the system except government spending is still a problem.
Top real estate and banking officials are calling on the Federal Reserve to stop raising interest rates as the industry suffers through surging housing costs and a "historic shortage" of available homes for sale.
In a letter Monday addressed to the Fed Board of Governors and Chair Jerome Powell, the officials voiced their worries about the direction of monetary policy and the impact it is having on the beleaguered real estate market.
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On October 5, 2023, Treasury Secretary Janet Yellen made a very telling statement about the future course of interest rates.
YELLEN SAYS DEBT SERVICE COSTS WILL BE 1% OF GDP FOR THE NEXT DECADE. – Reuters
Her statement implies that the economy will be strong and the government will run budget surpluses, or interest rates will be near zero for the next ten years.
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She'll be long dead."Her statement implies that the economy will be strong and the government will run budget surpluses, or interest rates will be near zero for the next ten years."
Janet Yellen will be in for a rude awakening if she truly thinks that.
... the minutes of the Federal Reserve's September monetary policy meeting show that the central bank is committed to maintaining a "higher for longer" monetary policy stance.
Although the Federal Reserve is nearing the end of its tightening cycle, the minutes showed that the committee continues to support elevated interest rates until it is confident that inflation is falling back to the 2% target.
"All participants agreed that policy should remain restrictive for some time until the Committee is confident that inflation is moving down sustainably toward its objective," the minutes said. "Several participants commented that, with the policy rate likely at or near its peak, the focus of monetary policy decisions and communications should shift from how high to raise the policy rate to how long to hold the policy rate at restrictive levels."
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Prices that consumers pay for a wide variety of goods and services increased at a slightly faster-than-expected pace in September, keeping inflation in the spotlight for policymakers.
The consumer price index, a closely followed inflation gauge, increased 0.4% on the month and 3.7% from a year ago, according to a Labor Department report Thursday. That compared with respective Dow Jones estimates of 0.3% and 3.6%. Headline inflation increased 0.6% in August.
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... Chairman Jerome Powell gathers the Economic Club of New York for a fireside chat on Thursday.
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Our call of the day from Macro Tourist newsletter editor, Kevin Muir would tend to agree, as he says Powell’s comments have important bearing on markets for the next two months.
Muir believes some investors way too caught up in recent data that shows a strong economy. “I will not disagree with the analysis that the U.S. economy appears to be running at full steam with no signs of slowing,” Muir writes in his latest blog.
“However, I think they are mistakenly looking solely at the economic data and not considering financial conditions,” and given post-FOMC meeting moves in asset prices, it’s easy to see that the Fed sees the market doing its tightening work for it, he says.
What investors tend to forget, crucially, is that the Fed is a “supertanker that takes a long time to start and stop,” says Muir. And it doesn’t shift direction due to a couple of data points, but rather looks at the whole enchilada and figures out “gradual starts and stops.”
The big debate right now? As economic data has been a little too hot, the bond market thinks the Fed will leave chances of a December hike on the table. Muir says nope, the Fed has paused and it will take some seriously strong economic data to get that hiking campaign restarted.
On Thursday, Muir expects Powell will be more dovish than many investors expect, and confirm what other members have been saying over the past week, suggesting he will echo what Fed Vice Chair Philip Jefferson said recently.
Jefferson: “I will remain cognizant of the tightening in financial conditions through higher bond yields and will keep that in mind as I assess the future path of policy. I will be taking financial market developments into account along with the totality of incoming data in assessing the economic outlook and the risks surrounding the outlook and in judging the appropriate future course of policy.”
A more dovish Fed may not be a green light to buy stocks, said Muir, though he’s considering buying some inflation protected bonds and gold and selling the dollar, and he’s also not sure how bond yields will react due to so many variables. “However, I don’t think betting on a hawkish Powell is the correct play.”
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JPMorgan Chase CEO Jamie Dimon on Tuesday warned about the dangers of locking in an outlook about the economy, particularly considering the poor recent track record of central banks like the Federal Reserve.
In the latest of multiple warnings about what lies ahead from the head of the largest U.S. bank by assets, he cautioned that myriad factors playing out now make things even more difficult.
"Prepare for possibilities and probabilities, not calling one course of action, since I've never seen anyone call it," Dimon said during a panel discussion at the Future Investment Initiative summit in Riyadh, Saudi Arabia.
"I want to point out the central banks 18 months ago were 100% dead wrong," he added. "I would be quite cautious about what might happen next year."
The comments reference back to the Fed outlook in early 2022 and for much of the previous year, when central bank officials insisted that the inflation surge would be "transitory."
Along with the misdiagnosis on prices, Fed officials, according to projections released in March 2022, collectively saw their key interest rate rising to just 2.8% by the end of 2023 — it is now north of 5.25% — and core inflation at 2.8%, 1.1 percentage points below its current level as measured by the central bank's preferred gauge.
Dimon criticized "this omnipotent feeling that central banks and governments can manage through all this stuff. I'm cautious."
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Let me go through some of the mechanisms by which higher interest rates affect financial stability.
The most immediate way, and the one behind the UK pension fund crisis and the demise of Silicon Valley Bank, are valuation losses on assets. How quickly these losses materialise in banks' earnings and capital depends on the accounting treatment of interest-sensitive assets. For Latin American, Canadian and larger US banks, authorities require mark-to-market accounting for securities held both in the trading and banking book when "available for sale". This results in a rapid recognition of the effects of valuation changes on capital. However, this does not apply to medium-sized banks in the United States – some of which are actually quite large by the standards of other countries. In fact, we have seen unrecognised losses increase again, to $558.4 billion at end-Q2 (hold-to-maturity: $309.6 billion; available-for-sale: $248.9 billion) (FDIC (2023)). Since then, Treasury yields have increased by approximately 1 percentage point, suggesting that unrealised losses could be considerably higher today.
Higher interest rates also affect financial institutions' interest income and expenditure. In most emerging market economies, banks rely heavily on interest income. However, interest rate risk is largely managed with the provision of short-maturity loans and the use of time deposits, resulting in a low sensitivity of interest income to policy rates.
High interest rates also increase the debt service burdens of households, firms and governments. This comes at a time when high inflation has been eroding the purchasing power of salaries and moderating growth reduces actual and prospective earnings as well as tax revenues.
We have not yet seen a major rise in non-performing loans in most countries. In Latin America, non-performing loans have remained low by historical standards. They have also barely increased since central banks started hiking rates.
Banks' provisioning policies suggest that they expect defaults to remain low in the coming quarters. Also, the disinflation and potential rate cuts suggest that some borrowers could soon see relief as well.
But this does not mean that we are out of the woods and should discard credit risks.
First of all, credit risk takes longer to materialise than valuation losses, from both an economic and an accounting point of view.
Second, the relatively low level of non-performing loans observed so far may still be somewhat supressed by the various monetary, fiscal and regulatory measures during the pandemic. For instance, many fiscal support programmes for borrowers are being phased out.
Third, banks' benign loss projections may not fully reflect macroeconomic risks. A recent BIS working paper found that banks are good at predicting which assets are riskier than others, but they are generally not able to predict changes in aggregate losses (Birn et al (2023)). In fact, for the vast majority of banks, the correlation between the evolution of expected and actual losses over time is not different from zero! This should make us sceptical about banks' ability to predict the impact of higher interest rates on credit losses.
Fourth, aggregate figures may hide pockets of vulnerability. While overall credit growth in the Americas was moderate in recent years, there were booms in specific categories. For instance, consumer and credit card lending in Brazil and Mexico have grown fast. In Canada, the high stock of mortgages could create large rollover risks for households. And in the United States, riskier market segments such as high-yield debt, leveraged loans and office real estate are already experiencing higher default rates and are forecast to go notably higher.
Finally, interest rates could remain high for some time. ...
Recent indicators suggest that economic activity expanded at a strong pace in the third quarter. Job gains have moderated since earlier in the year but remain strong, and the unemployment rate has remained low. Inflation remains elevated.
The U.S. banking system is sound and resilient. Tighter financial and credit conditions for households and businesses are likely to weigh on economic activity, hiring, and inflation. The extent of these effects remains uncertain. The Committee remains highly attentive to inflation risks.
The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. In support of these goals, the Committee decided to maintain the target range for the federal funds rate at 5-1/4 to 5-1/2 percent. The Committee will continue to assess additional information and its implications for monetary policy. In determining the extent of additional policy firming that may be appropriate to return inflation to 2 percent over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments. In addition, the Committee will continue reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities, as described in its previously announced plans. The Committee is strongly committed to returning inflation to its 2 percent objective.
In assessing the appropriate stance of monetary policy, the Committee will continue to monitor the implications of incoming information for the economic outlook. The Committee would be prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee's goals. The Committee's assessments will take into account a wide range of information, including readings on labor market conditions, inflation pressures and inflation expectations, and financial and international developments.
Voting for the monetary policy action were Jerome H. Powell, Chair; John C. Williams, Vice Chair; Michael S. Barr; Michelle W. Bowman; Lisa D. Cook; Austan D. Goolsbee; Patrick Harker; Philip N. Jefferson; Neel Kashkari; Adriana D. Kugler; Lorie K. Logan; and Christopher J. Waller.
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Bill Dudley, who led the Federal Reserve Bank of New York between 2009-2018, wrote in a Bloomberg column that he sees “four potentially fatal flaws” in policymakers’ thinking and that “they could be making a big mistake” by keeping rates on hold.
His warning came earlier on Wednesday, just hours before the policy-making Federal Open Market Committee voted unanimously to keep its main interest-rate target at a 22-year high of 5.25%-5.5%. One of the reasons for the Fed’s pause is the recent steep rise in long-term Treasury yields, which is helping to tighten financial conditions.
In a nutshell, Dudley said that Fed Chairman Jerome Powell is risking a repeat of the 1970s-1980s, when inflation spiraled out of control under Arthur Burns and required a severe U.S. recession under Paul Volcker.
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Economists at U.K. bank Barclays, one of the primary dealers for U.S. Treasurys, pushed back their call for a Federal Reserve rate hike to January.
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According to the CME FedWatch tool, markets are pricing in a 10% chance of another rate hike by December, and a 16% chance of a move by February.
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Federal Reserve officials have not discussed what it would take to cut interest rates, Minneapolis Fed President Neel Kashkari said Tuesday.
Asked in an interview on Bloomberg about “a feeling in the market” that the bar to cut interest rates was not as high now as it was previously, Kashkari replied: “I have no idea where market participants are getting that. There’s no discussion amongst me and any of my colleagues about when we’re going to start preparing to cut rates.”
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What if the Fed were doing exactly the wrong thing? What if, by raising short-term interest rates, it was actually adding to inflation instead of cutting it?
That’s the argument being made by chief investment officer Travis Cocke and his team at Voss Capital, a Houston, Texas-based fund company that has been beating the market for years.
And if they are right, or even just partly right, it would help explain why inflation has remained so strong, despite the Fed’s repeated interest rate hikes.
(There again, the federal government’s persistence in running massive budget deficits may also explain why the economy is running so hot.)
The Voss Capital argument is counterintuitive but not crazy. In a nutshell: Higher interest rates aren’t hurting consumers and companies as much as the Fed thinks, because so many locked in low long-term interest rates during the golden days of the zero interest rate policy. Consumers refinanced their mortgages for 30 years at 3% or less. Companies issued long-term bonds on similar terms.
So raising short-term rates doesn’t raise the cost of these debts, because the money has already been borrowed and the rates fixed.
Meanwhile, many consumers and companies have lots of cash in the bank or in money market funds. Raising interest rates means, suddenly, this money is generating way more interest income than it was before.
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"All" they gotta do is require all retirement accounts to be invested by a certain % in gov debt. Ie: run it like Enron. LolNo one, well not nearly enough. That's why what the FED wants is irrelevant. Rates are gonna go sky high.
Federal Reserve Governor Christopher Waller said Tuesday he's growing more confident that policy is in a place now to bring inflation back under control.
There was nothing in Waller's prepared remarks for a speech in Washington, D.C., that suggests he's contemplating cutting interest rates, and he noted that inflation currently is still too high. But he pointed out a variety of areas where progress has made, suggesting the Fed at least won't need to hike rates further from here.
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