Forward guidance: Avoiding financial market turmoil would help the Fed remain restrictive for "some time"
From: Bill Nelson <Bill.Nelson@BPI.com>
Date: Monday, October 31, 2022 at 1:09 PM
Subject: Forward guidance: Avoiding financial market turmoil would help the Fed remain restrictive for "some time"
Apologies for the long period without an email – I only send one if I think I have something useful to add, and my views on monetary policy have largely tracked the market consensus: The FOMC will raise its target range by 75 basis points Wednesday and leave open whether they will tighten by 50 or 75 basis points in December. Chair Powell may indicate a slightly greater receptivity to a downshift to 50 basis point hikes than he has done in the past
One reason a downshift may be a bit more firmly on the table has to do with the economy. Although the stance of policy is still stimulative – the nominal funds rate is below the underlying pace of inflation rather than more than 50 basis point above it – there has been an extraordinarily rapid shift in that stance. The nominal funds rate has not increased this rapidly since 1981, and that increase was followed by a severe recession. It takes about six quarters for a change in policy to reach its peak effect on the economy. The Committee may want to slow down slightly to give the cumulative economic consequences of their tightening a chance to catch up and to give policymakers a chance to assess those effects.
The second reason for a possible downshift has to do with financial stability. The Committee has clearly and repeatedly indicated that it plans to raise the funds rate to a restrictive level and maintain a that stance for “some time.” A serious bout of financial distress could derail that plan. Extremely rapid tightening is a greater threat to financial stability than merely rapid tightening. Accounts of Treasury market illiquidity abound, reportedly in part because increased interest rate volatility has led to tighter VaR constraints on market participants’ ability to take positions.
The illiquidity reportedly also owes to regulatory constraints on the ability of bank-owned broker-dealers to deploy balance sheets to Treasury market intermediation. In March 2021, Chair Powell stated that the Board would fix the leverage ratio “soon,” but there has been no action so far. GSIB surcharges and stress tests also punish financial market intermediation, and the two combined have raised GSIBs’ average capital requirement by 130 basis points since 2020. My colleagues Francisco Covas, Katie Collard, and Brett Waxman recently showed (see here ) that 50 basis points of that increase is simply the result of the banks’ higher holdings of reserve balances.
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The current situation is in some ways an inverted version of the one in 2014 (see two notes that I wrote with Greg Baer, here and here ). In 2014, the FOMC was winding down its asset purchases and deciding how strongly to indicate that it intended to keep interest rates near zero after the purchases were over. At the same time, several FOMC participants were concerned that low rates were causing investors to seek higher yields by choosing riskier products. As a way to maintain consensus across the Committee for strong forward guidance, the Board published strident FAQs on leveraged loans that had been issued and then sold by banks even though then Governor Daniel Tarullo, Nellie Liang, and others judged that the loans presented neither a financial stability nor a bank safety and soundness risk.
In current circumstances, by contrast, there is widespread agreement that there are legitimate steps the Fed and the other banking agencies could take to enhance the resilience of the Treasury market, and the Fed could take those steps now to increase the likelihood that it will be able to maintain a restrictive stance of policy for long enough to bring down inflation. The Fed is also in the midst of developing major changes to its bank capital framework, and it should be cognizant of possibly unintended ways the framework discourages financial market intermediation.
The FOMC will receive a financial stability briefing this week based on the material that will make up the November Financial Stability Report. Perhaps Chair Powell will shed some light on how they view the financial stability situation and the prospect for the Board taking steps to improve the resiliency of the Treasury market in the near term.
All that said, only a slightly stronger emphasis on the possibility of a 50-basis point hike in December seems likely. There are two employment reports and two CPI releases before the December meeting. Moreover, the Committee will be especially loath to take an action that will move markets materially so close to an election.
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Bill
Bill Nelson | Chief Economist | Bank Policy Institute | bill.nelson@bpi.com
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2yRight, treasury market performance seems an unlikely source of systemic risk particularly as it can be so directly affected. Whatever systemic risk there is for the banking sector there maybe has already been baked in. By definition we don’t know what it is or if it is just yet as the chips have yet to fall if they are to fall. Said another way black swans are invisible until they take wing
Excellent points about how reforming the leverage ratio and other excessive GSIB restrictions can help the economy without impairing prudential supervision.