What is the Fed up to?
Politics, Secret Crisis, or Soft Landing
A recently dovish Fed has been the subject of much speculation. That is because financial conditions are already loose while inflation is still above target as you can see in the chart below.
The blue line is the more volatile Consumer Price Index inflation and the red line is the “sticky” Consumer Price Index inflation, which is still at 3.6%.
The Fed always says that financial conditions are the main conduit of monetary policy to the economy. As you can see in the chart below, financial conditions have been loosening since March 2023.
Why then is the Fed signaling multiple reductions in interest rate during 2024? A few answers are “out there”.
I heard Marko Papic, a geopolitical strategist, on MacroVoices say that the Fed will likely become political and assist Biden’s reelection by boosting the economy.
I then heard Michael Lebowitz on Thoughtful Money say that “the Fed might be scared of something they're not telling us about”.
The third option is that the Fed is simply following the data. Inflation is cooling, and the economy is slowing. Therefore, given the long time lag, it is time to begin planning the reduction in Federal Fund Rates.
The last piece of the puzzle was on the
post about liquidity. As you can see in the chart below, liquidity is computed by JP Morgan by subtracting the Reverse Repo (RRP) and Treasury General Account (TGA) from the Fed’s Balance sheet (B/S).
The bottom line is that liquidity went up because the RRP decreased. I beg to differ.
The Reverse Repo facility was introduced because of too much reserves on banks balance sheets. These reserves were not producing enough income and the banks wanted to swap them for income generating treasuries.
Through the RRP, the Fed borrowed excess reserves from the banks and lent them income producing treasuries.
A reduction in the RRP tells me that banks needed their reserves back! And that means that deposits left the banks to chase stocks, money market funds and treasuries.
Now back to the Fed.
Its long term project is reversing the damage of Quantitative Easing (QE), which was introduced by Bernanke. QE did nothing for Main St. but created a huge asset bubble on Wall St. And the consequence was inequality.
As you can see in the chart below, the Fed created $5 Trillion of “high powered money” during the Great Financial Crisis and the Covid Crisis.
When this high powered money is combined with fiscal deficits, it becomes extremely inflationary. We’ve seen it in action in 2021 and 2022. What’s more, having a huge liquidity cushion reduces the efficacy of rate hikes.
And that is why reversing QE is a major priority. But if banks get in liquidity trouble again, the Fed might need to stop Quantitative Tightening (QT).
I believe that defending QT is the real reason for interest rate dovishness. I’m glad that I have some traps under regional banks. They might have rallied for the wrong reason. Liquidity left their balance sheets to buy their stocks. Crazy…