The Fed's $4.5 Trillion problem


The Federal Reserve's (Fed) rate hike of 25 basis points last week has sent mixed signals to global investors. While the Fed's Open Market Committee (FOMC) voted 9-1 in favor of raising rates, the Fed signaled that there would be two more hikes in 2017. Some investors had expected a more aggressive approach by the Fed and the market had priced in more and faster tightening by the FOMC and absent that, markets reversed course.

The dollar's weakness against major currencies following the Fed's announcement signals that investors don't want to risk staying with the greenback in the face of higher inflation without being compensated through higher interest rates. The lone dissenter at the FOMC, Neel Kashgari of the Minneapolis Fed, offered other ways to tighten (tighten WHAT??) as an alternative to the classic hike in the target of the Federal Funds Rate. Currently in a band of 75 to 100 basis points, the Federal Funds Rate is still at historic lows even as inflation stays below the 2 percent target set out by the Fed. Kashgari argues that the Fed shouldn't treat the 2 percent target as a ceiling, meaning it's not the end of the world should inflation exceed that level.

The president of the Minneapolis Fed went on to argue for fewer yet more aggressive rate hikes when needed. Instead of hiking 25 basis points at a time, which has been the norm since the Great Recession, Kashgari argues that the Fed could increase the magnitude of hikes at each meeting, if necessary. Kashgari also pointed out that the current Fed balance sheet, in excess of $4.5 trillion will ultimately need to be wound down. The Fed has the ability to "print" money and loan itself said money, interest-free. During the period of "quantitative easing," the Federal Reserve did exactly that, "print" money. The Fed went on to purchase U.S. government treasury bonds, thus lowering the borrowing cost of the Federal Government while artificially increasing the price of these bonds.

The Fed also purchased troubled assets, especially mortgaged-backed securities in an effort to save the owners of those assets from potential collapse, preventing contagion. Had the Fed not intervened in keeping this market afloat, the mortgage market would have completely collapsed, which would have subsequently sent shock waves throughout the greater economy. With the purchases of bonds, the Fed now sits upon the largest portfolio of government securities in the world. Even China and Japan's vast portfolio of U.S. government securities pale in comparison to the Fed's. With no clear mandate to continue rolling over these securities ad infinitum, the Fed will ultimately have to sell-off said assets. Kashgari argues this step, off-loading these securities, is a de facto tightening of the policy rate in and of itself. He's correct.

The selling-off of these assets will take time and cause a drop in prices while pushing yields higher. To prevent steep drops, the Fed would need a sustained long-term approach to clearing its balance sheet. Kashgari's argument, that clearing these assets is tightening, should be heeded in lieu of rate hikes. While rate hikes may cause inflation to slow, they will also adversely and directly impact businesses. It is not clear that selling off the securities in the Fed's portfolio will cause such a direct result. At the very least, this option needs to be discussed in a transparent fashion so as to clear the Feds' portfolio as a policy tool.

I doubt the ability of the Trump administration to pass their budget as proposed last week. I also believe the fiscal spending Trump plans may be curbed by Republican hawks in Congress. This means much uncertainty will remain as the FOMC makes its next policy decision. This delay in the ability of the Fed to make such decisions will push back any subsequent rate hikes and thereby prevent the Fed from achieving its stated three hikes this year.

The United Kingdom triggers "Article 50" next week and begins the multi-year process of exiting the European Union. This will add another measure of uncertainty even as the U.S. ramps up involvement in armed conflicts in the Middle East. The year 2017 will not be as smooth sailing as markets would like and this will prevent the Fed from acting. Look for sustained dollar weakness as a result.

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