QVMS - The Fed Speaks Inflation On Its Mind

Summary

• The statement of the Federal Open Market Committee concerning the recent 25 basis point rise in the Fed's policy rate of interest was received fairly well in the financial markets.
• Still the main policy thrust by the Fed is the reduction of its securities portfolio through the process of quantitative tightening.
• In its statement, the FOMC concentrated on returning inflation to the Fed's 2.0 percent goal, something the financial markets seem to have built into some yields.
• But, the battle is not over, for there's still lots and lots of liquidity existing in the banking system. How this will impact the Fed's battle against inflation is unknown.

The Federal Reserve raised its policy rate of interest by 25 basis points at the latest meeting of the Federal Open Market Committee.

The FOMC statement that included the news of this increase stressed one very important point : A goal of 2% inflation.

"The Committee is strongly committed to returning inflation to its 2% objective."

The Committee includes this point three times in its short statement.

I think that the more important confirmation, however, is the one the Committee makes with respect to the Fed's securities portfolio.

The Committee states that:

"... The Committee will continue reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities, as described in its previously announced plans."

In other words, the Fed will continue to quantitatively tighten up on the banking system.

Continue to expect that the Fed will reduce the size of its securities portfolio every month for an extended period of time.

So far, since the middle of March 2022, the Fed has reduced the size of its securities portfolio by almost $430.0 billion.

In the four weeks ending on January 25, 2023, the Fed saw its securities portfolio drop by just under $82.0 billion.

The FOMC statement says that the Fed will continue to follow "previously announced plans" in continuing to reduce the size of its portfolio.

Here's what the path looks like so far.

This is what the Fed is calling "Quantitative Tightening."

When the Fed does "Quantitative Easing" the chart looks pretty much the same except the curve bends upwards to the right rather than downwards.

The picture is the same, however.

In the case of Quantitative Tightening, the Fed is reducing the amount of securities that it holds outright in a relatively steady, relatively smooth path. The crucial thing in the execution of the policy is that amount of decline in the portfolio on a weekly basis is relatively steady and occurs week after week after week.

This activity in the financial markets signals investors that the Fed is presenting no surprises and is aiming to continue on into the future just as it is currently doing.

The Fed in the 2010s and early 2020s has conducted four rounds of Quantitative Easy. The current program is the Fed's first effort at Quantitative Tightening.

So far, so good.

But, this is where, I think, investors are watching the wrong thing.

So much fuss is being made over whether or not the Fed raises its policy rate of interest and by how much it raises the rate when it does raise it.

To me, the policy rate moves now just reflect the Fed's efforts to maintain stable money markets. The Policy rate changes are to achieve a short-term equilibrium consistent with the liquidity positions of the commercial banks.

The Fed continues on its policy to reduce the size of its securities portfolio and this creates certain pressures in the money markets.

The Fed then adjusts other tools so as to make sure that the new policy rate of interest remains steady.

So, policy rate changes are not the crucial element in the Fed's efforts to combat inflation.

The size of the Fed's securities portfolio is the primary tool to keep down inflation.

Inflation Expectations

It's interesting to me that investors seem to accept the conclusion of the policy.

As noted before, the forecasts of the Fed that are used to make decisions in the Federal Open Market Committee already show the Federal Reserve attaining its 2.0 percent goal in four or five years.

Note that the Inflation Expectations built into the current yields in the bond market have already built this 2.0 percent inflation goal into market prices.

For example, the inflationary expectations built into the yield on the five-year U.S. Treasury note is right around 2.15 percent.

The inflationary expectations built into the yield on the 10-year U.S. Treasury note are roughly the same.

That is, the Fed's target goals for inflation over the longer run are now actually incorporated into the present market rates of interest.

This is quite an unexpected accomplishment.

Market Response

The initial response of the stock market was negative.

At one time the S&P 500 Stock Index was down around 100 points.

But, after Mr. Powell spoke and investors had time to think about things a little more, the S&P actually closed up by about 50 points.

So, the market response to today's news from the Federal Reserve seems to have turned out positive.

There are still many, many questions to answer, but for now things seems to be smooth.

My concern is still about whether or not investors are fully understanding the primary focus of the current Fed policy.. . quantitative tightening.

The major question still not answered is whether or not the Fed will be reducing its securities portfolio by a sufficient amount to reduce the liquidity now in the banking system due to the asset bubble the Fed created to fight off the effects of the COVID-19 pandemic crises that was threatening the U.S.

Right now, the commercial banking system has about $3.0 trillion in excess reserves.

The original proposal of the Fed to reduce the size of its securities portfolio did not come close to reducing the excess reserves in the banking system back to a reasonable number. There are just so much "excess" funds around, the issue is whether or not the Fed can really reduce them enough.

But, the current interest rate increase has taken place.

The response seems to be positive.

So we have avoided another "bump" for the time being.

But we still have a long way to go.

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