close
close

topicnews · September 17, 2024

Uncertainties regarding Fed interest rate cut shake balance sheet outlook – News

Uncertainties regarding Fed interest rate cut shake balance sheet outlook – News

The US Federal Reserve in Washington, DC. At a meeting of the Federal Reserve this week, central bankers are widely expected to cut interest rates. — AFP

Published: Tuesday, September 17, 2024, 4:20 p.m.

Uncertainty about the extent of the US Federal Reserve’s first interest rate cut expected on Wednesday has sparked a related debate about the possibility of an accelerated halt to the central bank’s balance sheet reduction.

In interest rate futures markets, the prospect of a half-percentage-point rate cut has increased from a smaller quarter-percentage-point cut earlier this week. If policymakers do indeed go for the stronger option and signal that they are concerned about the economic outlook, the path to further quantitative tightening (QT) could become significantly shorter.


QT is widely seen as a liquidity management tool and is different from the Fed’s interest rate policy, which aims to dampen inflation without putting too much pressure on the labor market. However, depending on the reasons for the rate cuts, more aggressive Fed rate cuts could be seen as contradicting tighter liquidity.

An impending end to the QT would significantly change the outlook for the central bank’s balance sheet. A survey of large banks by the New York Fed in July found that firms predicted the end of the QT in April next year, while Fed officials signaled they saw sufficient scope for the QT to continue.



“If they cut rates by 50 basis points, I think the balance sheet decision becomes more complex,” says Patricia Zobel, a former manager of the New York Fed’s monetary policy group and now head of macroeconomic research and market strategy at Guggenheim Investments.

“We have some chance” of an earlier end to the QT if a larger cut is accompanied by economic concerns, Zobel said. Currently, the former Fed official expects a quarter-percentage point cut and a continuation of the QT on its current path.

The Fed is currently aiming for a key interest rate in a range of 5.2 to 5.50 percent.

Matthew Luzzetti, an economist at Deutsche Bank, said a sharp rate cut combined with hints of more aggressive easing in policymakers’ updated forecasts to be released on Wednesday would mean “there would be a trade-off between rate cuts and further balance sheet contraction, and in this environment they may not want such a mixed signal about their policy tools.” Bank of America analysts, meanwhile, agreed that a half-percentage point cut to support the economy would end QT relatively soon.

The heightened uncertainty about rate cuts stems from the assessment of whether the Fed will simply cut borrowing costs to normalize them in the face of easing inflation. Some say that one or two more big cuts are possible along the way. But the bigger risk to the QT forecast is that interest rate policy will be adjusted due to increasing concerns about a labor market stall.

Still plenty of liquidity

The clouded outlook for the balance sheet comes after the QT process just passed the two-year mark. The Fed has more than doubled the size of its holdings through the summer of 2022 through purchases of Treasuries and mortgage-backed securities, bringing its holdings to $9 trillion. The purchases were aimed at calming jittery markets and giving the economy a boost beyond the near-zero percent interest rates as the COVID-19 pandemic raged. The QT process began when the Fed moved to raising interest rates to curb inflation and officials decided that excessive easing was no longer appropriate. The unwinding has cut Fed holdings by about $1.8 trillion so far, and in May the Fed slowed the planned $95 billion monthly unwinding to the current limit of $60 billion.

The Fed strives to maintain sufficient liquidity in the financial system to allow for normal short-term interest rate volatility and firm control over the federal funds rate. So far, the discussion about ending the QT program has largely revolved around finding the optimal point for liquidity.

QT “will not be adjusted until the Fed thinks it has made the transition from ample reserves to sufficient reserves,” said William Dudley, who headed the New York Fed until his retirement in 2018. “They don’t know exactly where and when that will happen, but they are pretty confident they are not there yet,” he said.

So far, QT has been running completely in the background. It has lost importance as a market driver because investors have already “built” QT into longer-term borrowing costs, said John Williams, president of the New York Fed.

Meanwhile, former St. Louis Fed Chairman James Bullard, now dean of Purdue University’s business school, pointed out that QT and interest rate policy are, at least for now, aligned and could remain so even if interest rates are cut.

“Even if you lower the policy rate a little bit, it will still be above the generally expected neutrality. So you would still be running a restrictive monetary policy in terms of the policy rate, and that complements the part of the policy that is aimed at quantitative tightening,” Bullard said.

When the policy rate is around neutral, Bullard said it would be time to think about ending QT to better align the two policy tools. Analysts at research firm LH Meyer said any move toward a policy rate of 3 percent or less would in itself be a trigger for ending QT.


You may also like...