The Federal Reserve Board has acted as if they are terrified by QT and they haven't really explained why. This is exemplified by their decision to simply let the MBS portfolio run off rather than selling into the market, a strategy that doesn't work for reasons we've looked at previously.*
Here's a first rate examination of the issues from The Institutional Risk Analyst (also on blogroll at right):
“All propaganda is lies, even when one is telling the truth,” George Orwell concluded after working for the British Broadcasting Company (1941-1943). “I don’t think this matters so long as one knows what one is doing, and why.”
Orwell's time as an editor at BBC followed a period working as a colonial policeman in Burma. "“In a time of deceit telling the truth is a revolutionary act,” he said years later. Chairman Powell and the Federal Open Market Committee need to accept that they cannot raise fed funds further without causing serious financial problems for banks and other institutions. Time for truth.
Readers of The Institutional Risk Analyst know our views on Fed interest rate moves, but last week’s market action really begs the question as to the credibility of FOMC policy. Until the Committee completes the circle and starts to actively sell mortgage backed securities (MBS), the markets simply don’t and won’t believe that Powell and the FOMC are serious about raising interest rates to fight inflation.
The big takeaway from last week’s FOMC meeting is confusion on the part of the Committee members and the markets about the direction of interest rates. Komal Sri-Kumar wrote last week:
“Credibility is a terrible thing to waste. I wrote in January about at least two instances when Powell either turned dovish when hit by a cratering stock market (December 2018), or persisted in forecasting “transitory” inflation to justify his vastly expansionary policies (2020 - 2022). Market’s belief that he is a soft touch when it comes to inflation reduction explains why equities have rallied despite his seemingly tough message at the press conference.”
Why does the Fed need to sell MBS from the system open market account (SOMA)? Because only by releasing that massive duration locked away inside the sterilized confines of SOMA back into the markets can the FOMC get long-term interest rates above 4%. Adjusted for option-adjusted duration, the Fed's $2 trillion MBS position is larger than its portfolio of Treasury debt. Ponder that Chair Powell. Selling bonds is also a tangible manifestation of FOMC policy, distinct and apart from the speculations of the media & economist chorus about the target for fed funds.
Finally, selling bonds and pausing further fed funds rate increases will not put additional pressure on banks and will actually increase asset returns. The FOMC should not mistake the current calm in the bank funding market for a solution to the illiquidity and losses created by raising short-term interest rates over 500bp in a year. The chart below shows bank deposits through the first week in June vs the Treasury General Account. Bank deposits fell $80 billion in a single week. Total runoff for the rest of 2023 could be more than half a trillion dollars even if the Fed does not raise the target rate for fed funds again.....
....MUCH MORE
*If interested see:
- Former Philadelphia Fed President Charles Plosser: "Why The Fed Should Only Own Treasuries"
- Former Philadelphia Fed Head Plosser On The Federal Reserve Balance Sheet With Comments On the Mortgage Backed Securities Portfolio
- Fed Purchases Of Mortgage Backed Securities Have Destroyed The Housing Market
- The Mortgage Backed Securities Trap The Federal Reserve Set For Itself, In One Chart
- "How and Why the Fed Should Tweak QT"
- Atlanta Fed Head Raphael Bostic On Mortgage Backed Securities: "We are going to have to actively try to sell them."
It's a very big deal and The Institutional Risk Analyst piece is the best, most concise explanation of what to do that I have seen.
