The Fed’s Monetary Policy Conflict – Easing And Tightening Simultaneously

The Fed’s Monetary Policy

The Federal Reserve, or the Fed, is the largest and most important financial institution in the world.

As the central bank of the United States, the Fed conducts Monetary Policy to promote stable prices and maximum employment in our economy. This is often referred to as the Fed’s “Dual Mandate.”

The Fed utilizes two main tools to achieve their Dual Mandate objectives. The first is by setting the level of short-term interest rates, and the second is by adjusting the amount of reserves, or liquidity, in the banking system through the use of Open Market Operations.

The Fed’s most effective tool, and the one they go to first, is raising or lowering the target range for the Fed Funds rate. When the economy is sluggish, or inflation is low, the Fed “Eases” Monetary Policy by reducing the Fed Funds Rate, which is often referred to as stepping on the gas, to get things moving. When inflation is too high, or the economy is strong, the Fed “Tightens” Monetary Policy by raising the Fed Funds Rate, which typically is referenced as stepping on the brakes, to slow things down.

Utilizing the other tool of Open Market Operations, the Fed “Eases” Monetary Policy by purchasing securities, thereby injecting liquidity to the financial system, and the Fed “Tightens” Monetary Policy by reducing its securities holdings, thereby withdrawing liquidity from the system. In the post-GFC period, the purchase of securities has been known as Quantitative Easing (“QE”) and the reduction of securities has been known as Quantitative Tightening (“QT.”)

Historically, these two tools have been used in concert. When the Fed is easing, they lower the Fed Funds Rate and inject liquidity through QE, and when the Fed is tightening, they raise the Fed Funds Rate and drain liquidity through QT.

Until now.

Fed To Ease And Tighten Simultaneously

The FOMC is about to create a large internal Monetary Policy conflict, as they begin Easing and Tightening, simultaneously, for the first time ever.

When the Fed concludes their sixth FOMC meeting of the year on Wednesday, we project that they will ease Monetary Policy by cutting the Fed Funds Rate by 25 basis points. This would be their first interest rate cut in four and one-half years, since the pandemic began in March 2020.

At the same time, the Fed will continue with their QT program of draining reserves.

Fed Chairman Powell forewarned of this occurrence in his first Press Briefing of 2024, following the January FOMC meeting, when he mentioned that at some point this year the Fed will cut rates. When queried about cutting rates and allowing balance sheet runoff in tandem, he said, “from a strict monetary policy standpoint, you could say we’re loosening along with tightening.”

He went on to say that he felt that both were Policy Normalization and that “we see those as independent tools.”

The gas pedal and the brake pedal of a car are also independent. But no one steps on the gas and steps on the brake at the same time when driving. Not to mention the physical strain of using both together has on the mechanical integrity of the car, or the damage it can cause.

What will be the effect of the Fed’s internally conflicted Monetary Policy on the economy?

We’re about to find out.

Why the Fed Will Cut Rates

Chair Powell has been waiting all year to have the data that will provide him with more confidence that inflation is headed to the Fed’s long-term goal of 2%. Focusing on the Fed’s preferred measure of inflation, the Core PCE, he’s seen it fall from 4.2% over the past 12 months to 2.6%, where it has stabilized for the past three months. All while the Fed Funds Rate has remained fixed in the range of 5.25% to 5.50%.

On the unemployment front, we’ve seen the unemployment rate creep up from a low of 3.4% in January 2023 to the current level of 4.2%. This increase triggered the Sahm Rule, created by economist Claudia Sahm, formerly of the St. Louis Federal Reserve and the Council of Economic Advisors.

The Sahm Rule is used as a recession indicator. Simply put, the Sahm Rule is triggered when the three-month average of the unemployment rate hits 0.50% or more than the lowest three-month average of the unemployment rate from the past 12 months. By using three-month averages, the Rule smooths the impact of a large one-month variance. Once activated, the Rule suggests that the economy is in the early stages of a recession.

With inflation coming down, and the unemployment rate rising enough to set off the Sahm Rule, Chair Powell felt that the upside risk to inflation had diminished and the downside risk to employment had increased. This combination, together, brought him to the conclusion he uttered last month at the Fed’s Annual Symposium in Jackson Hole that “the time has come for policy to adjust.”

With that statement, which in Fed speak is the equivalent of ringing the bell, the Fed will cut rates at the end of their FOMC meeting on Wednesday. The Fed moves gradually, so the first cut will be 25 basis points.

The Fed will also release a new Summary of Economic Projections, which will provide further guidance on the Fed’s thinking for the future path of interest rates.

Quantitative Tightening to Continue

At the same time, the Fed will continue with their Policy Normalization Plan of executing Quantitative Tightening.

An important element of the Fed’s Monetary Policy over the past two- and one-half years has been the implementation of QT.

During the Great Financial Crisis of 2008 and Pandemic, the Fed embarked on several rounds of Quantitative Easing, which caused the Fed’s Balance Sheet to grow from $900 billion to almost $9.0 trillion. QE was employed during a time of crisis, and was always intended to be temporary.

The fear of QE was that the injection of tremendous amounts of liquidity to the financial system would be inflationary.

But as time went on and the economy recovered, inflation remained quite tame. While prices initially remained under the Fed’s benchmark target of 2.0%, inflation appeared in a different segment of the financial world, creating asset bubbles. With interest rates near zero, and so much liquidity floating around, the Fed’s actions forced people to invest in riskier assets.

Money poured into the stock market. And with interest rates so low, money also poured into the housing market. As the economy recovered, asset prices continued to rise; stocks, housing, gold and digital currencies set new high after new high.

Eventually, the feared impact on price inflation of the Fed’s massive liquidity injection kicked in. When the Fed finally began implementing their Policy Normalization Plan in 1Q22 to fight the spike in inflation to 40-year highs, QT was an important element, in addition to aggressively raising the Fed Funds Rate.

While the stated goal of Policy Normalization was to tame inflation, the expectation of draining liquidity through QT was that the asset bubbles would also deflate. But that hasn’t happened.

QT has been in place for 28 months, and the Fed has been pleased with its progress. The Fed has trimmed its balance sheet from $8.885 trillion to $7.115 trillion, a 20% decline. However, the balance sheet is still 70% larger than when the pandemic began, and almost 700% larger than pre-GFC.

When Will QT End

While no one thought we would return to the pre-GFC sized balance sheet, as the Fed has changed its method of executing Monetary Policy from the Scarce Reserves Regime to the Ample Reserves Regime, more progress has been expected.

For a detailed explanation of the Fed’s new method of conducting Monetary Policy, please refer to my recent Seeking Alpha Article “Fed Meeting Preview: The Future Of Quantitative Tightening.”

The Fed has been vague on what is the proper level of Reserve Balances to maintain. In their Policy Normalization discussion, the Fed has simply said “Over time, the Committee intends to maintain securities holdings in amounts needed to implement monetary policy efficiently and effectively in its Ample Reserves Regime.”

In reducing reserves, the Fed learned from its first experience with QT from 2018-2019, not to cut too quickly. During September 2019, repo rates spiked dramatically, rising from 2% to 10% intraday, as liquidity imbalances popped up in the banking system.

As a result, they decided to slow the pace of QT, beginning in June 2024. The amount of Treasury Securities they would allow to run off each month was cut to $25 billion from $60 billion. The monthly cap for MBS run-offs remained the same at $35 billion, although the actual pace of MBS run-offs is in the $15 billion to $18 billion per month range.

Dallas Fed President Lorie Logan stated at a recent Monetary Policy conference, that “slowing…doesn’t mean stopping. In fact, …proceeding more gradually may allow the Fed to eventually get to a smaller balance sheet.”

The Fed has been conducting research on the proper level of reserves. In an August 2023 analysis by the St. Louis Fed, “The Mechanics of Fed Balance Sheet Normalization,” the authors concluded that the desired level of liquidity was 10-12% of GDP. That would put liquidity in the range of $2.8 to $3.3 trillion.

The current level of liquidity on the Fed balance sheet is $4.1 trillion, comprised of $3.4 trillion of Bank Reserves and $0.7 trillion of Reverse Repurchase Agreements.

Over the past 18 months, the liquidity drain due to the Fed’s QT has come from the Reverse Repurchases Agreements, as can be seen in the red of the above chart. Bank Reserves have remained relatively stable, as seen in the blue above. Dallas Fed President Logan stated, “As long as there are significant balances in the ON RRP facility, we can be confident that liquidity is more than ample in the aggregate. But once the ON RRP is empty, there will be more uncertainty about how much excess liquidity remains.”

Last month, the Federal Reserve Bank of New York published a two-part study “When Are Central Bank Reserves Ample?” which highlights measures to assess the ampleness of reserves in real time. The study proposes some daily indicators of reserve ampleness.

Clearly, the Fed’s recent research and their tapering of QT demonstrates they are monitoring the path to when it is time to stop QT. However, they are reluctant to pick an exact level. As President Logan commented, “I don’t think we can identify the ample level in advance. We’ll need to feel our way to it by observing money market spreads and volatility.”

Why Continuing QT Is Important

The Fed wants to drain as much liquidity from the system as possible to continue its battle with price inflation and to deflate the asset bubbles.

In addition, as I’ve written about previously, the Fed has a large asset/liability mismatch, whereby they own fixed rate assets that are funded with variable rate liabilities. The mismatch has caused them to lose money for going on eight consecutive quarters, to the tune of almost $200 billion dollars.

The Fed wants to unwind this asset/liability mismatch and go back to a balance sheet where they own primarily short-term Treasury Securities, and eliminate their operating losses and return to profitability.

The only way for them to get there is through QT.

Historical Experience

There is no historical equivalent to the expected new Monetary Policy conflict of simultaneous easing and tightening.

Part of the reason is that the current Monetary Policy framework of an Ample Reserves Regime has only been in place since 2008, a short 16-year portion of the Fed’s entire 111-year existence.

During that period, there was only one other time when the Fed moved from a tight policy to an easy policy. That happened in 2019. The Fed had been tightening, utilizing both higher Fed Funds Rates from 2017-2019 and executing QT. When the Fed decided it was time to switch gears and lower rates to stimulate the economy and raise inflation, they also elected to end their QT program.

The only other somewhat comparable episode occurred in the spring of 2023, when the Fed was confronted with a regional banking crisis, culminating with 3 of the 4 largest bank failures in American history. The Fed came to the rescue of the banking industry wearing its other hat of lender of last resort. To bail out the failed institutions and protect the rest of the banking industry, the Fed provided additional liquidity through different lending facilities, including the newly created Bank Term Funding Program.

These rescue programs temporarily offset the Fed’s liquidity drain from QT, but had no impact on changing the direction of the Fed Funds rate.

Conclusion

The world’s most important financial institution, the Fed, is about to embark on an extremely conflicted Monetary Policy when they begin easing by cutting the Fed Funds Rate by 25 basis points at the conclusion of the FOMC meeting. This will be done to achieve their Dual Mandate goals of stable prices and maximum employment.

At the same time, they will continue draining liquidity through QT as part of their Policy Normalization Program.

Never before have they eased and tightened simultaneously.

This conflicted policy is also being executed when financial assets are at record high, inflated prices.

Over the past five years, starting one quarter before the pandemic hit:

S&P 500 +92%

Housing Index +57%

Gold +74%

Bitcoin +675%

In addition, the Fed is implementing this unorthodox, conflicted Monetary Policy at a time that they are about to record their eighth consecutive quarterly loss, with a cumulative deficit of almost $200 billion.

Although the market has been clamoring for the Fed to pivot on rates for more than two years, and the Fed is finally succumbing to this demand, one could argue that it is still too soon for the Fed to cut rates.

The Fed has not yet reached its price inflation target of 2%, and asset prices remain inflated. For example, the crisis in housing of historic levels of unaffordability will not be solved by a 25 basis point cut in the Fed Funds Rate when home prices are at record highs.

Regarding the unemployment rate ticking up, the Sahm Rule has never been invoked from such a record low level of unemployment. Plus, the unemployment rate is ticking up not from people losing their jobs, which is a sign of a weakening economy, but because more people are entering the workforce. In this case, none other than Claudia Sahm herself has said that “right now, the Sahm Rule is overstating the weakness in the economy.”

By executing simultaneous easing and tightening, the Fed is stepping into new territory and will be exerting unprecedented strain on its operational tool kit. Time will tell how effective this new course of action will be.