Over the past year the Federal Reserve has driven up interest rates by nearly 500 basis points in its quest to try to tamp down inflation.
From a range of 0.25%-0.50% back on March 17, 2022, the Fed since then has steadily raised its target for its benchmark federal funds rate to 4.75%-5.00%, with the possibility of more to come. Over that time the Fed has raised rates nine times—four times by 75 basis points, twice by 50 bps, and three times by 25 bps.
At its two most recent meetings, in February and March, the Fed raised rates by only 25 bps each, possibly because it saw fit to take a slight pause and measure the effect of all these rate increases to see if they are having the desired effect of slowing the economy in order to bring down inflation.
Of course, as we know, the rate hikes haven’t done a whole lot in reining in inflation.
Rather, they created a panic among some fairly large regional banks that has unsettled the entire banking industry, the effect of which has done more to slow the economy than raising rates has done.
Should the Fed then say that the ends justify the means, even if the means—creating the panic—were totally accidental? Should the Fed now brand its “policy normalization” program a success even if a couple of banks failed in the process? Let’s hope not.
This fiasco does call attention to the other prong of that normalization process, namely a reduction in the Fed’s massive balance sheet, which was supposed to help raise long-term interest rates gradually and lessen the Fed’s presence in the U.S. economy.
On that score, there has been negligible progress.
Back in the good old days, before the 2008 financial crisis, the Fed’s balance sheet never totaled more than $1 trillion, a figure that now looks fairly quaint, yet it was a mere 15 years ago.
Then, of course, Lehman Brothers failed, residential real estate prices crashed, millions of people lost their homes, and the Fed in just a few weeks had pumped enough money into the economy to raise its balance sheet to more than $2 trillion by the end of that year.
But that was only the beginning. Over the next several years, as the economy had trouble growing more than 1% a year, the Fed more than doubled its government and mortgage bond portfolio to more than $4 trillion. Then came the Covid-19 shutdown, and between February 2020 and the middle of last year the balance sheet had more than doubled again, to just under $9 trillion, at which time the Fed said it would start trimming it.
While the balance sheet has indeed come down, it’s certainly debatable if enough progress has been made on this score. Indeed, just as the Fed started to make some minimal progress in reducing its portfolio, it has started to increase it again.
The balance sheet hit a peak of just under $9 trillion last July, at which point it started to recede gradually, falling to $8.3 trillion early last month.
But then guess what happened? The Fed found itself blindsided by the SVB banking crisis it had largely created itself, had to pump more money into the economy to calm nervous depositors and investors, and before you knew it the balance sheet was back up to $8.7 trillion by the end of the month.
So, while the Fed has squarely focused all of its vaunted “tools” on raising short-term interest rates, it hasn’t made any commensurate progress on raising long-term rates by reducing its balance sheet.
Indeed, it appears to be artificially “propping down” long-term rates by insisting on having such a gigantic bond portfolio, which continues to distort conditions in the bond market.
If the Fed was as serious as it claims to be in “normalizing” interest rates, it could do a lot more. But then it probably would trigger another crisis and have to intervene in the markets yet again.
The Fed’s next monetary policy meeting is scheduled for May 2-3. Right now it’s difficult to bet what its next move will be.
Some expect another 25 bp hike, some believe the Fed will stand pat and make no change, while still others are hoping the Fed will “pivot” and actually lower rates if there is enough evidence that its previous rate hikes have finally put a meaningful dent in inflation.
I think that’s a little too much wishful thinking, and would not be surprised by another 25 bp hike.
However, what would be welcome would be some kind of announcement that the Fed is taking a closer look at putting a significant dent in its balance sheet.
With long-term Treasury bond yields so low, it’s doubtful that such a policy move would unsettle the markets too much. But it might have an impact on raising long-term rates, thereby reducing inflation while guiding the economy to a soft landing.
George Yacik
INO.com Contributor
Disclosure: This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.
