Whether Consumer Price Inflation (CPI) or Personal Consumption Expenditure (PCE), consumer inflation results from demand for consumer goods and services exceeding the supply of consumer goods and services.
Changing monetary policy does not directly impact the money in consumer pockets the way changing fiscal policy does. The Federal Reserve’s changes in the fed funds rate only indirectly impacts consumers.
The fed funds rate is an overnight interest rate which influences longer-term rates to a certain extent. But Quantitative Easing (QE), which the Fed flooded into the banks, directly impacts longer-term interest rates and especially the price of assets like stocks, bonds and real estate. Our investments float on a bathtub full of free money like toy sailboats. The Fed’s bloated book of assets impacts our investments more directly than the fed funds rate.
Stock Market Calm Rekindles Debate Over Fed Tightening
The Federal Reserve’s balance sheet might be insulating Wall Street from the effects of interest-rate policy
By Eric Wallerstein, The Wall Street Journal, April 30, 2023
The Federal Reserve’s balance sheet, loaded with bonds purchased to support the economy during crises, might be insulating Wall Street from the effects of its interest-rate policy. Growth has slowed but inflation remains persistent in key areas, raising concerns that the balance sheet’s size — about one-third of U.S. gross domestic product — could force the Fed to take rates even higher, prolonging the pain in markets…
Fed officials and economists have acknowledged that shrinking the balance sheet can tighten financial conditions, though they have played down the potential impact. The Fed doesn’t view its balance sheet as an important tool for tightening monetary policy and Chair Jerome Powell rejected the idea of using anything other than rate changes at his latest news conference.…
Officials decided in May 2022 to shrink the Fed’s balance sheet by allowing some maturing debt to roll off. Policy makers in September upped the amount of securities that can roll off its portfolio each month to $60 billion of Treasurys and $35 billion of mortgage-backed securities…
Mostly shorter-term assets have rolled off. The Fed’s Treasury holdings currently have an average maturity above eight years, weighted by the dollar amount invested. More than a quarter of those mature in more than 10 years. By comparison, the full universe of Treasurys has a weighted-average maturity closer to six years, according to the New York Fed…
The latest projections from the New York Fed show the central bank’s holdings falling to $6 trillion in 2025. … [end quote]
The Fed intends to allow the bonds to “roll off” – to mature but not be replaced by reinvesting in new bonds. They won’t sell their bonds because that would depress bond prices in the open market (raising interest rates) but also because these bonds are worth less than their par value due to the increase in interest rates. They will receive par value at maturity, not if sold today. Like other banks, the Fed would be underwater if their bonds were marked to market.
If the Fed was really serious about Quantitative Tightening they would sell some of their bonds. But Fed Chair Powell said that the Fed would only use the fed funds rate, which is not very effective at impacting consumer inflation. The Fed’s QT is very gradual. Even so, it was almost completely reversed by the new program to support Silicon Valley Bank by buying Treasury bonds at par (even though their market price is much lower).
The Fed’s program to shed mortgage debt instead of buying it has impacted mortgage rates. Investors had grown accustomed to the Fed’s support, which had ballooned to become roughly a third of the total market. Yields on GSE mortgage bonds are now significantly higher than the equivalent Treasury yield. The 30 year mortgage rate is at the highest since 2006.
The Fed is very aware that the asset markets would react violently if they tightened at longer durations so they won’t do it. The plug will remain in the bathtub except for a very gradual leak.
The markets were partly sunny last week as predicted in the METAR. The stock market rose but remains in its stable channel. The bond market stabilized. The trade is neutral, neither risk-on nor risk-off. The Fear & Greed index is slightly higher than neutral.
Financial stress was low.
The Atlanta Fed’s initial GDPNow model estimate for real GDP growth (seasonally adjusted annual rate) in the second quarter of 2023 is 1.7 percent on April 28. The initial estimate of first-quarter real GDP growth released by the US Bureau of Economic Analysis on April 27 was 1.1 percent. This is slow growth but not recession.
Building projects are supporting employment.
The market remains convinced the the Fed will raise the fed funds rate 0.25% on May 5 but will pivot and cut later this year. The market is equally convinced that inflation will subside to just over 2% within 5 years.
The METAR for next week is partly sunny. The markets are stable. There is no news that will upset them in the next week barring a Black Swan event. The federal debt limit mess is more than a week away.