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Why the Fed might be at ‘neutral’ already 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 observing it. It’s easy to do. Anyone can play the game and attacking the Fed is like shooting sitting ducks: officials at the central bank cannot respond immediately given their public role.

Recently, Fed Chairman Jay Powell was spitted by his critics for claiming that Federal Funds interest rates were “neutral” on July 27. press conference just after the policy-making Federal Open Market Committee voted unanimously to raise the benchmark Federal Funds rate by 0.75 percentage points to 2.25 to 2.50 percent.

His suggestion that the Fed is on the brink of restrictive territory and therefore closer to tightening has been well received by both bond and equity investors, but not by the Fed’s critics.

Former President of the Federal Reserve Bank of New York, William Dudley said on Wednesday that given the level of uncertainty, “I would be a little more skeptical” in saying that policymakers had gone neutral.

Two days later, former Treasury Secretary Lawrence Summers was more critical. He accused Powell’s wishful thinking, similar to the Fed’s delusion last year that inflation would be transitory. He accused Powell of saying things “which, to be blunt, were analytically indefensible”. He added: “There’s no way that a 2.5 percent interest rate, in an economy inflating like this, could be anywhere near neutral.”

There’s even a conceivable way Powell could be right after all. The Fed’s critics ignore that the central bank has been more aggressive in word and deed than the European Central Bank and the Bank of Japan. Both official interest rates are still at or near zero.

As a result, the value of the dollar has risen 10 percent this year. In my opinion, that equates to an increase in Federal Funds interest rates of at least 50 basis points. In addition, the Fed has just started its quantitative tightening program to unwind the massive asset purchases to support the markets and the economy in recent years.

From June through August, the Fed will decrease reducing its balance sheet by maturing securities, which will reduce its holdings of Treasury bills by $30 billion per month and its holdings of government debt and mortgage-backed securities by $17.5 billion per month. So that’s a drop of $142.5 billion over those first three months of QT.

As of September, the drain is set at $60 billion for government bonds and $35 billion for agency debt and MBS. That’s $95 billion per month, or $1.14 trillion through August 2023. There is no specific amount or end date specified for QT.

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In my view, QT also equals an increase of at least 0.50 percentage point in the Federal Funds interest rate. In addition, in the December 2021 minutes from the FOMC, published on January 5 this year, investors learned that “some participants” on the committee preferred to get out of mortgage financing entirely.

That would be done by trading the Fed’s MBS for Treasuries and letting them drain as they mature below QT. This would have further increased the supply of MBS to the market to counter the upward pressure on mortgage rates relative to Treasuries. No wonder the 30-year mortgage rate rose from 3.30 percent at the start of this year to a high of 6.00 percent on July 15 and 5.46 percent now.

I conclude that the spike in the federal funds rate will be lower than usual during the current monetary tightening cycle, as the combination of QT and the strong dollar equates to an increase of at least 1 percentage point in the federal funds rate.

Moreover, the extraordinary jump in both short and long-term interest rates in the fixed income markets has already fueled much of the tightening for the Fed. In my view, the markets have already discounted a peak federal funds rate of 3 to 3.25 percent – and there it will soon be assumed that the Fed will raise rates again by 0.75 percentage points at the end of September, as widely expected.

By the way, on October 1, 2020, Dudley, when he was at the Fed, justified a second round of quantitative easing in the amount of $500 billion in securities purchases, said to be equivalent to a 0.50 to 0.75 percentage point cut in the federal fund rate.

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

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