Fed Guy

personal views of a former fed trader

Stock and Flow

The stock effects of monetary tightening are clearly disinflationary, but the flow effects are less clear. The Fed’s rapid tightening markedly reduced the level of household wealth and thus potential demand, but the bulk of asset repricing seems to be behind us. The impact of tighter policy going forward is less certain because higher rates restrain some sectors but subsidize others. Interest income from reserves, RRP, and newly issued Treasuries rise along with rate hikes and can potentially increase demand. In addition, households and corporations borrowed at historically low rates and have been largely insulated from recent hikes. This post walks through the cross currents of higher interest rates and suggests the relative ineffectiveness of the Fed’s policy tools may lead to a more aggressive policy response.

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Quantitative Buybacks

A Treasury buyback program today would be mechanically equivalent to quantitative easing and a tailwind for risk assets. Buybacks funded by bill issuance would move cash out of the RRP and into the broader financial system. The end result would be an increase in cash held by banks and non-banks, both whom may rebalance their portfolios into other assets. In addition, the reappearance of a steady bid for coupon Treasuries would put downward pressure on yields and boost market liquidity. This post shows why buybacks would be mechanically equivalent to QE, reviews two channels QE operates to boost risk assets and suggests a potential shift in the conduct of monetary policy.

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Solvency Constraints

The dollar rally may be set to continue as limits on quantitative tightening bind other central banks before it binds the Fed. The tail risks of QT have first appeared in the gilt market, where significant price volatility prompted official intervention. What appears to be a liquidity issue will ultimately become a financial stability issue as investors discover their “safe assets” are not safe. These concerns may prompt a policy response similar to that seen in Japan, where the price of sovereign debt is explicitly supported. Just as yield curve control led to significant Yen weakness, so a similar move by other central banks would also severely weaken their currencies. This post describes the link between bonds and financial stability, notes the existence of a central bank “put” on bonds, and suggests other central banks would likely cave first.

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The Reserve Gap

A rapid decline in the level of bank reserves would be an obstacle to QT that may prompt action from the authorities. An aggressive QT was premised on first draining the large RRP balances, but the monetary plumbing suggested that was never likely. Banks can easily maintain their own reserve levels, but their own target levels are significantly below those of the Fed. This implies that bank reserve levels will likely fall below the Fed’s comfort level far before QT is slated to end. In this post we sketch out the Fed’s dilemma, show why its options are limited, and suggest that Treasury buybacks or SLR adjustments would likely be used to boost bank reserve levels.

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Fed Balance Sheet FAQs

This post answers four frequently asked questions on the Fed’s balance sheet. The answers to the first two questions will affirm that the Fed is executing QT exactly as promised, even if it may not appear that way. The apparent discrepancy is due to TIPS appreciation and details in MBS settlement mechanics. The answers to the second two questions will show how the Fed balance sheet behaves when the Fed has and negative net interest income or capital losses. The Fed has special accounting rules where losses appear as “deferred assets” that will be repaid out of future earnings.

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The Marginal Buyer

Treasury buybacks would be a powerful tool that could ease potential disruptions arising from quantitative tightening. The Treasury hinted in their latest refunding minutes of potential buybacks, which is when Treasury issues new debt to repurchase old debt. Buybacks can be used to boost Treasury market liquidity, but more importantly also allow Treasury to rapidly modify its debt profile. By issuing bills to purchase coupons, Treasury could strengthen the market in the face of rising issuance and potentially structural inflation. An increase in bill issuance would also facilitate a smooth QT by moving liquidity out of the RRP and into the banking sector. This post reviews the basics of Treasury buybacks and explains how it could be an important tool in managing Treasury market stability and Fed liquidity flows.

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The Money Still Flows

The market appears to misunderstand the Fed’s reaction function and is pricing a path of policy that is not consistent with a return to 2% inflation. Inflation moderates through demand destruction when households can no longer afford the price increases. But the sources of household purchasing power – credit, wages, and wealth – all appear to easily support elevated inflation. These metrics may not indicate that a 9% inflation rate is sustainable, but they are much too high for a 2% target inflation rate. The market’s eagerness to price in a dovish Fed pivot early next year is worsening the situation by effectively easing financial conditions before inflation has even peaked. This post reviews the strength of household purchasing power along the three sources and suggests a dovish Fed pivot is far away.

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One Armed Fed

The Fed’s current focus on inflation over full employment may be a preview of monetary policy in a world where the supply of labor is structurally declining. An aging population implies a persistent decline in the supply of labor, even as demand for labor remains strong because retirees continue to consume. The economic implications of this new regime are previewed through the recent wave of early retirements: lower unemployment, higher wages, higher inflation, and weaker growth. These circumstances reduce the employment costs of tighter policy, potentially changing the Fed’s reaction function by freeing policy to more aggressively target inflation. Recall, the Fed’s mandate is full employment and price stability, not positive economic growth. In this post we review a theory on how aging demographics raise inflation, illustrate its implications with the recent wave of early retirements, and suggest higher interest rates will become structural.

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Don’t Fight The Fed

The Fed has developed enough new tools that there are almost no limits to how far it can tighten. Prior tightening cycles often led to financial instability that prompted sudden easing, but that was before the revolution of March 2020. At that time the Fed acted as lender of last resort to not just the typical financial sector entities, but also to real economy entities including municipals, corporations, and even small businesses. The emergency facilities were intended to transmit low rates to the real economy even when the financial system malfunctioned, but those facilities can also be used to transmit higher rates. An aggressive tightening will likely lead to cracks in financial markets before inflation is tamed. In that case, the Fed now has the tools to support the real economy and keep tightening until the last ounce of inflation is squeezed out. This post reviews the Fed’s tool kit, notes still it lacks one important tool, and suggests Fed tightening can be more aggressive than expected.

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Turbo Tightening

The money supply is set to contract just as investors are clamoring for cash to hide from declines in both equities and bonds. A combination of increasing MMF allocation to the RRP and QT may drain ~$1t of bank deposits by the end of the year. The Treasury’s decision to further cut bill issuance will keep money market rates very low and likely push the RRP to over $2.5t by the end of the year. Furthermore, recent history suggests QT will largely be funded by deposits held in banking system rather than the RRP. The combination of these two mechanisms suggests a net contraction in bank deposits despite elevated bank credit creation. Investors looking to hide in cash will have to compete for a shrinking pool of cash by further lowering the asking prices of their assets. In this post we describe the mechanics behind the impending rapid withdraw of cash and suggest the market rout will continue.

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