A non-fatal Fed mistake

Yesterday the FOMC decided to reduce its short-term interest rate target by 25 bps. It was a move in the right direction (as I suggested in late May), but as today's market action demonstrated, it was an overly cautious move, particularly in light of escalating global trade tensions (i.e., Trump's tariffs, which today he threatened to ratchet higher). The US economy, as well as most major global economies, are facing headwinds, uncertainties, and slower growth, all of which have increased risk-aversion and the demand for money equivalents. A 25 bps cut to short-term interest rates helps offset the world's increased demand for money (by making money and money-equivalents less attractive), but only partially.

A bigger cut would have been better, but this was not a fatal mistake. Why? Because the level of real interest rates remains relatively low, and liquidity conditions—thanks to the still-abundant supply of excess bank reserves and the low level of 2-yr swap spreads—are still quite healthy. The market is likely to be on edge for awhile, but there is still time for the Fed to correct this mistake and/or for trade tensions to dissipate and risk-aversion to recede.

Chart #1

Chart #2

Chart #1 shows 5-yr real and nominal interest rates, and the difference between the two (green line), which is the market's expectation for what the CPI will average over the next 5 years. Interest rates have declined significantly so far this year, but inflation expectations have only subsided slightly. That's because the most important decline in interest rates has been in real yields, which are a proxy for the market's expectation for future economic growth rates, as Chart #2 suggests. Real yields are down because the market is losing confidence in future economic growth prospects. Inflation expectations have also subsided somewhat, which further suggests that the market thinks monetary policy is a bit too tight.

Chart #3

Chart #3 compares the real yield on 5-yr TIPS (the best measure of market-based real yields that is readily available) with the real Fed funds rate (which is the current Fed target rate minus the rate of core PCE inflation over the past year). Bond market math dictates that the red line is what the market expects the blue line to average over the next 5 years. The market is expecting further Fed rate cuts—about 2-3 more at the present time—over the next year. This is the market's way of telegraphing to the Fed that monetary policy is too tight and that lower interest rates are needed. Note also that the blue line marks the very front end off the real yield curve, while the red line marks the intermediate area of the real yield curve. When the blue line exceeds the red line, the real yield curve is inverted (as it is now), and that is a good indication that the economy is likely to slow down. Inverted yield curves are almost always a sign of slower growth to come.

Chart #4

But the shape of the yield curve is not the whole story. The other important part of the story is the level of real yields, which is shown by the blue line in Chart #4. In the past, every recession has been preceded by high real yields and a flat or inverted yield curve. Today we have only one of those indicators: the shape of the yield curve, which is slightly inverted. Real yields remain historically low. thus, a recession is far from inevitable.

Chart #5

Prior to the Great Recession, the Fed had only one way to tighten monetary policy, and that was to reduce (or increase) the supply of bank reserves. That typically resulted in higher (or lower) short-term interest rates. Today, the Fed doesn't need to increase the supply of bank reserves in order to force short-term interest rates lower. It simply declares that it will pay a lower rate of interest on excess bank reserves, which, as Chart #5 shows, are abundant—to the tune of almost $1.5 trillion.

Chart #6

With bank reserves still abundant, swap spreads are still very low, as Chart #6 shows. This means that liquidity conditions in the financial market are very healthy. Nobody is being starved for money. Money in fact is now easier to get thanks to lower interest rates. This is a very important difference compared to prior episodes of monetary tightening or easing. Things are VERY different this time around.

It's a mistake to think that although it appears that today's monetary conditions are a bit tight (e.g, inverted yield curve, lower prices for risky assets), the economy is at risk. The Fed doesn't need to reduce interest rates in order to "bail out" the economy or to give it a shot of stimulus. The purpose of adjusting short-term interest rates lower under the current monetary regime of abundant excess reserves is not to "stimulate" the economy but rather to keep the supply of money in line with the demand for money. That, in turn, will keep financial markets healthy, avoid asset price bubbles and keep inflation low and relatively stable. Remember, monetary policy was never meant to stimulate or throttle growth. Growth is not created magically when the Fed lowers interest rates. Monetary policy is meant to keep the supply and demand for money in balance, and thus to deliver low and stable inflation, which in turn is conducive to growth.

The Powell Fed was too cautious in its decision yesterday, but it was not a fatal mistake.