Power & Market

Powell’s Plot Holes

The market continues to rejoice in the prospect of several rate cuts coming next year. According to the Fed’s own projections, things appear to be quite promising:

If the economy evolves as projected, the median participant projects that the appropriate level of the federal funds rate will be 4.6 percent at the end of 2024, 3.6 percent at the end of 2025, and 2.9 percent at the end of 2026, still above the median longer-term rate.

Lower rates may sound like a relief for those burdened with high mortgage loans or a government on the verge of hitting the $34 trillion debt mark any day now. However, something to closely monitor in 2024 will be the “why” and the “how” of the Fed’s plan to reduce rates.

The Fed is unlikely to explicitly state that they are cutting rates to prevent national bankruptcy, support the stock market, or influence a presidential election. Instead, anticipate discussions revolving around inflation data, unemployment figures, and various data points provided to justify their rationale.

A potential issue arises if inflation data is relatively high, and the Fed aims to cut rates, which conflicts with the Fed’s principle that high rates “fight inflation.” Powell addressed this when questioned about a decision to lower rates with inflation readings at 2.5 to 3.5%.

He remarked:

I mean, the reason you wouldn’t wait to get to 2 percent to cut rates is that policy would be, it would be too late. I mean you’d want to be reducing restriction on the economy well before 2 percent because -- or before you get to 2 percent so you don’t overshoot…

In simpler terms, the Fed might lower rates while prices are still relatively high to prevent prices from dropping too low…

Even if not credible, selling unclear economic theory is the easy part. And we can bet they’ll continue to spin their story whichever way suits their objectives. The difficult part lies in the actual mechanism used to reduce rates.

There exists a crucial relationship between the Fed’s buying and selling of debt, influencing the demand for bonds, and subsequently impacting interest rates. It’s not a direct 1:1 calculation that can be predicted daily; rather, it should be considered in a broader, real-world sense. For instance, if the Fed is purchasing trillions of dollars in bonds with newly created money, bond prices are likely to rise, and interest rates will decline. Conversely, an extreme scenario where the Fed decides to sell trillions of dollars of bonds at once would drive bond prices down and push interest rates up.

The latter example is akin to the Fed’s Quantitative Tightening (QT) since 2022, albeit at a slower pace, involving letting matured bonds expire without buying as many each month. The rate increases we’ve seen in this period are hardly coincidental.

So herein lies the problem, because it’s not easy to drive a car with the foot on the brake pedal.

If the Fed wants to lower rates in 2024, what’s going to happen to QT, and will it not facilitate a new round of QE?

If markets are hot right now, then just wait until hundreds of billions, if not several trillions are produced to manipulate interest rates. Of course, this becomes most viable to the public in the event of a global financial crisis.

Fortunately, Powell made some allusion to this, in his second to last sentence at his press conference when asked about the balance sheet vis-a-vis interest rates. His answer was hardly pretty, but gives a flavor of things to come.

(The “two things” he’s referring to are changes to the balance sheet and changes to interest rates).

You know, if you’re cutting rates because you’re going back to normal, that’s one thing. If you’re cutting them because the economy is really weak. So you can imagine, you’d have to know what the reason is to know whether it would be appropriate to do those two things at the same time.

One last thing to take to heart is something he emphasized twice:

…the full effects of our tightening likely have not yet been felt.

In 2024, the narrative will change in many ways, but can the same be said about the Fed’s control over both the money supply and interest rates? One might almost think that an economic crisis would be the best thing for the Fed, as it would give them a reason to take on emergency interventionist measures, most notably being the use of their digital printing press.

Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.
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