Bloomberg has a significant story that matches my Fed balance sheet reduction hypothesis from the beginning.
An unexpected rise in overnight interest rates is pulling forward a key debate among U.S. central bankers over how much liquidity they should keep in the financial system. The outcome will determine the ultimate size of the balance sheet, which they are slowly winding down, with key implications for U.S. monetary policy.
One consequence was visible on Wednesday. The Fed raised the target range for its benchmark rate by a quarter point to 1.75 percent to 2 percent, but only increased the rate it pays banks on cash held with it overnight to 1.95 percent. The step was designed to keep the federal funds rate from rising above the target range. Previously, the Fed set the rate of interest on reserves at the top of the target range.
Since beginning the shrinking process in October, the Fed has trimmed its bond portfolio by around $150 billion to $4.3 trillion, while remaining vague on how small it could become. Officials have said that, as they drain cash from the system by shrinking the balance sheet, a rise in the federal funds rate within their target range would be an important sign that liquidity is becoming scarce.
“We are looking carefully at that, and the truth is, we don’t know with any precision,” Fed Chairman Jerome Powell told reporters on Wednesday when asked about the increase. “Really, no one does. You can’t run experiments with one effect and not the other.” “We’re just going to have to be watching and learning. And, frankly, we don’t have to know today," he added.
Mark Cabana, a Bank of America rates strategist, said in a report published June 5 that Fed officials may stop draining liquidity from the system in late 2019 or early 2020, leaving $1 trillion of cash on bank balance sheets. Cabana, who from 2007 to 2015 worked in the New York Fed’s markets group responsible for managing the balance sheet, even sees a risk that the unwind ends this year.
If Cabana is correct, and I believe he is, there are at least four significant consequences.
Four Consequences to Fed Delays in Balance Sheet Reduction
- Downward pressure on interest rates : If Fed officials do opt for a bigger balance sheet and decide to continue telling banks to prioritize cash over Treasuries, it may mean lower long-term interest rates, according to Seth Carpenter, the New York-based chief U.S. economist at UBS Securities. “If reserves are scarce right now, and if the Fed does stop unwinding its balance sheet, the market is going to react to that, a lot,” said Carpenter, a former Fed economist. “Everyone anticipates a certain amount of extra Treasury supply coming to the market, and this would tell people, ‘Nope, it’s going to be less than you thought.”’
- Upward pressure on gold
- Downward pressure on the US dollar
- More free money to banks at taxpayer expense
Fed Rethink Hints
- The Fed increased interest it pays on excess reserves 20 basis points on Wednesday rather than the expected 25 basis points.
- The Fed significantly altered its FOMC statement about future policy.
Moreover, the Fed has to be at least a bit worried about housing.
I discussed those ideas, in detail, on Wednesday.
Gold is highly likely to be a benficiary of this set of actions.
Mike "Mish" Shedlock