Thoughts on the Federal Reserve
I was asked a question about the Federal Reserve actions this week. I figured I would answer in a note, rather than try and take a call while with the family at the beach.
The Fed and excess cash (liquidity) in the banking system
The Fed has about $2 T in cash in its reverse repo facility (RRP), and banks have another 3.3 T in demand deposits (DD). The Fed and banks comfort level on DD is about $2 T, so there is no less than $3 T in cash that needs to be sopped up out of the market to “balance” liquidity in the market.
Another way to measure this is the “excess” cash is the look at M2 money supply.
Growth between 2015 - 2020 before the pandemic was a little less than $1 T / year. By the end of 2022, this would put us at ~$18 T. We’re currently at ~$21.8 T. This puts us into a similar range of ~$3.8 T in excess cash / liquidity.
The Fed set up the RRP because they did not want short term interest rates to go negative when TBills went near 0%. There is about $4 T in money market funds that are required to invest in government backed securities (note the similarity in excess M2). The Fed is raising interest rates in part to alleviate this issue (as well as nominally to “crush” inflation).
The only thing the Fed can do to the current inflation rate is reduce the demand side of the economy. They do this by reducing liquidity (cash) and raising the cost of using other people’s money.
However, our current challenges are that in addition to too much cash in the system (demand problem), the supply side of goods & services has been significantly hampered by the government COVID response (aka shutdowns). The global shutdowns have “broken” the just-in-time inventory model for the supply of goods. The service shutdowns combined with the direct cash payments reduced the supply of workers to the markets. So the total supply side of the goods & services economy has been dramatically reduced while system cash has dramatically increased. Bang! We have rampant inflation.
In addition, energy pricing creates its own inflationary pressures outside of the above supply and demand issues. The supply side has been crushed by supply disruption from COVID, lack of investment, Russia-Ukraine War, and progressive regulatory policies. A perfect storm of badness.
In the short-term, the Fed cannot help the supply side of the economy. So, it does what it can.
Raising interest rates here helps reduce the Fed’s need to engage in the repo market as real interest rates will increase and reduces the yield spread between the RRF and TBills. The yield spread between the RRP and TBills at the beginning of the year was ~70 basis points (0.70%). Right now, the rising interest rates have reduced this spread and it is ~50 basis points (0.50%). This spread needs to drop much further for money market funds to reduce their use of the RRP and buy Treasuries. This will help get the Fed out of the TBill market.
With respect to draining money – Quantitative Tightening (QT) – The current QT schedule started this month at $47.5 B / month and accelerates to $95 B / month in 3 months.
This program is currently scheduled to go for a year, and is expected to drain ~$1.1 T from the system. If you combine this with the expected transition of money market funds to Tbills, then the Fed could reduce its need to provide assets to the RRP. However, as this money is still in money market funds, the change in M2 would be limited to the QT.
And while Federal deficits are still high, they are expected to fall by 65% in 2022 to $1.0 T, from $2.8 T in 2021. This would further reduce the need for the Federal Reserve to monetize the federal deficit and therefore it keeps new cash from entering the system. However, even after a year of raising interest rates and draining liquidity, we’re probably still going to be above trend on cash in the system (M2) by about $2+ T.
Since cash is being drained and new cash is not being added to the system, I believe demand will stabilize, and even decrease on a real basis, as consumers transition to higher prices on housing, transportation and living expenses.
On the supply side, we are beginning to see a release in supply chain issues. Inventories have been climbing and large retailers are even forecasting the beginning of sales to reduce them.
Lastly, oil production and refining will begin to pick up and demand reductions occur, just from pricing signals alone. Pressure on the administration & November election results will force some reduction on production regulatory issues. Energy prices should stabilize and possibly fall a bit.
So what does all this mean?
My thoughts - The Fed goes to 3-4% on the Fed Funds rate by the fall. Inflation “moderates” into a 4% range. Asset prices stabilize because of continued excess liquidity but remain stuck in a trading range. I believe this stuck-ness may be here for a very long time as we work through the excess liquidity and higher than “normal” inflation.
COVID issues continue to regress into the background. Everyone gets back to work, with a little more stress about daily price increases.
In short - the world is not ending, but it is changing.
The housing market is a bit of a wild card, but here too I think it stabilizes. Mostly because of the higher demand by institutional investors. I believe this is a more critical system problem that will play out in the coming decade or so. More to follow here on another note.
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