The Fed's Next Steps Are About Easing off the Monetary Brake, Not About the Data

Federal Reserve policymakers often say monetary actions are data dependent. That was appropriate in the fog of the pandemic dislocations when the economy veered off course and inflation was a worry. However, now that the economy has recovered to cruising altitude and the inflation updraft has cleared, the Fed’s decisions will be more concept- than data-dependent, at least for a while. The concept: return to a “neutral posture”. That’s why, having hit the brakes last year—pushing its interest rate far above investors’ inflation expectations of 2% forever—the Fed took a big step back despite upbeat economic reports.

If this seems obvious, it doesn’t seem to be in financial markets. They seem programmed still for the Fed’s data-dependent MO, judging by the sharp responses to upbeat September and October job reports. That’s when bond yields jumped ? percentage point across the board in the blink of an eye.

The aim for a “neutral policy” setting involves two monetary tools, one is the federal funds rate and the other is the balance sheet.

A neutral setting for the federal funds rate, which anchors all money market rates, of course is a bit theoretical because the proof of the pudding lies in the future impact of current policy. Most forecasts see a noninflationary (benign) economic outlook and that supports the case for a neutral policy rate setting. But the “neutral” idea, which is not about the current state of the economy, reflects many factors, including demographics, productivity, and global factors. A neutral nominal federal funds rate probably is around 3%. The current 4? to 5% rate is not neutral. So, if the Fed’s first cut seemed aggressive given no sign of economic trouble, that’s because the concept is becoming more relevant than the data.

Balance sheet actions, which indirectly affect long-term interest rates, are a second policy tool. Shrinking the balance sheet (QT in the parlance of financial market participants) is restrictive, because it keeps bond yields higher than they would be if the Fed were merely recycling maturing securities into new ones. The Fed’s balance sheet currently is $7 trillion. That’s down from $9 trillion in the spring of 2022. But it’s still higher than the $4.2 trillion just before the pandemic. That doesn’t mean the Fed needs to shrink its balance sheet by another $3 trillion. [And, of course, the Fed announced early in 2018 that it would not shrink the balance sheet back to the $1 trillion level seen prior to the 2008 financial crisis and instead would allow a much higher volume of reserves in the banking system and so change the way it managed its interest rate target].

How will we know when the end of QT is approaching? The ratio of reserve balances to the money stock may have an answer. The Fed eliminated legal reserve requirements in March 2020, so the volume of excess reserve, once a useful guide to a “normal” balance sheet, no longer is relevant. However, banks still need to hold reserves to handle day-to-day flows. So, the ratio of reserves relative to financial activity (approximated by the M2 measure of the money stock) offers a useful reference point.

With the Fed’s balance sheet shrinking by $25 billion monthly and financial activity expanding in line with 5% money growth, the ratio of bank reserves to money, which already is back down to where it was in the summer of 2020, may be back to pre-pandemic levels by this time next year. In that case, the Fed might bring its QT to an end by the end of the year.