My Question for Chair Powell
I have a question for the Federal Reserve:
It seems as though you continue to be amazed by the strength of the US economy and inflation running above target despite the tightening cycle that has been underway since the end of 2021. The economy simply hasn’t slowed as much as you would have expected despite 525-550bps of interest rate hikes over the last 2 years. And now as we are faced with the prospect of inflation running above target for an even longer period of time, you are having to consider whether or not rate hikes may still be warranted. Perhaps monetary policy isn’t really that restrictive afterall.
My question is why has the Fed been so reluctant to use the balance sheet tool as a more active monetary policy tool in order to help more rapidly bring inflation down to target? Why have you not considered a more aggressive reduction of the Balance Sheet via active selling of assets (MBS and USTs) rather than simply allowing rolloffs? At this point, wouldn’t it make more sense for the Fed to be more aggressive in reducing the size of its Balance Sheet in order to raise term premiums, steepen the yield curve, dampen animal spirits and bring down inflation expectations and inflation through the asset price/wealth channel rather than raising interest rates further?
Clearly, higher interest rates are already hurting various segments of the population that can least afford these higher rates as we are seeing auto loan and credit card delinquency rates rising so raising interest rates further from here is just going to hurt the poor/middle class even more. On the flip side, wealthier homeowners and corporates with locked-in low cost long term borrowings set during Covid are benefitting from higher interest rates on their savings and from interest rate “stimulus” checks paid out by the US government’s continued massive deficits. This Fed policy is only exacerbating wealth inequality and keeping inflation stickier than it needs to be.
The myopia around only using the interest rate tool and not the using the balance sheet tool more actively has been a mistake and it is only going to get worse now that tapering of QT has begun, which slows down the reduction of the balance sheet even further.
The Fed was quick to raise its balance sheet by nearly $5trn from March 2020 to March 2022 but has been painfully slow removing accommodation via QT, removing only $1.6trn over the last two years. And as far as bank reserves are concerned, given injections made during the SVB bailouts, reserves are actually now up from mid-April 2022 (after drawdown from 4/15/22 tax payments), suggesting that there remains way too much liquidity in the banking system to really support a return of inflation back to 2%. Recall that the repo crisis in Sept 2019 happened when banking reserves fell below $1.5trn so it seems like there remains a tremendous amount of room to reduce the balance sheet further before there would be any issues. We have over 100% more reserves in the banking system today than existing pre-Covid. There is simply no reason for this to still exist.
It is time for the Fed to course correct, admit mistakes and get about the business of quickly returning inflation to target. The answer is not additional rate increases that will hurt the poorest Americans while adding more to the US government deficits, and crowding out/slowing down private sector investment in new capacity for the supply chain. The answer is to get more aggressive on reducing the size of the balance sheet more quickly through asset sales that will go after the wealth channel to tighten financial conditions and allow long-end yields to rise in order to bring inflation back to target.
Important Disclaimer: This blog is for educational purposes only. I am not a financial advisor and nothing I post is investment advice. The securities I discuss are considered highly risky so do your own due diligence.
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