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JOHN MASON: The Fed's course to "Normalization"

The US Federal Reserve moves along to raise its policy rate of interest and reduce the size of its securities portfolio

BY: John Mason

Federal Reserve officials continue to adhere to their plan to increase their policy rate of interest three times in 2018, with the possibility of even having fourth rate rise during the year.

In March the Fed moved the target rate for the Federal Funds rate to 1.50 percent to 1.75 percent. The Fed’s “forward guidance” indicated that it would raise the range twice more this year, which would bring the range up to 2.00 percent to 2.25 percent. And, there is the chance that the Fed will even bring on one more increase by the end of the year, getting the policy rate range up to 2.25 percent to 2.50 percent.

This, Fed officials believe, would bring short-term interest rates in the United States closer to a “normal” level of interest rates for the economy.

Three more increases have been discussed for 2019, which, if implemented would bring the range up to 3.00 percent to 3.25 percent by the end of the year.

And, as of May 16, 2018, the end of the last banking week, the Federal Reserve has reduced the size of its securities portfolio by just over $113 billion since the end of the banking week, September 27, 2017 when the securities portfolio totaled $4,220 trillion.

The Federal Reserve has been running a little below its planned reduction schedule. By the end of May 2018, the Fed had hoped to have reduced the total amount of securities it held outright by $150 billion. So, Fed officials still have two weeks to get closer to the $150 billion total.

Overall, the Federal Reserve has reduced the size of its balance sheet by $117 billion, since September 27, 2017.

This is not an easy job because the Fed has many operating factors it must consider along with the reduction in the size of its securities portfolio. It must manage its balance sheet, taking these operating factors into account, so that the reserve position of the banking system is not disturbed.

If anything, the Federal Reserve always intends to operate on the side of providing too much liquidity to the banks rather than too little so as to avoid adjustment difficulties in the financial system. As a consequence, it is not surprising that the amount of reserves removed from the Fed’s balance sheet is less than originally targeted. It is good that the Fed is as close to target as it is.

The crucial question as far as the Federal Reserve is concerned is how long it will be able to continue its efforts to raise its policy rate of interest closer to where the rate could be considered to be in a “more normal” range.

One could argue that the targeted range the Fed hopes to achieve by the end of 2019 represents a “more normal” level for the Federal Funds rate. The question is, will the Federal Reserve be able to achieve this goal?

One problem with getting up to a 3.00 percent to 3.25 percent range is the level of the yield on longer-term securities. Right now, the yield on the 10-year US Treasury note is around 3.05 percent.

Concern has already been raised earlier this year about the “flat” US Government yield curve. Historically, as a business expansion nears its end, the yield curve becomes flatter and eventually “inverts” as short-term interest rates rise above longer-term interest rates.

So far in the calendar year 2018, the spread between the yield on the 10-year Government note and the yield on the 2-year government note has become smaller than at any other time of the current economic expansion.

On April 16, this spread dropped to 43 basis points and has remained near there since. Note: this was not long after the Fed’s last increase in the policy rate. Concern grew that this move might be signaling the end of the current business cycle.

An invested curve seemed likely to many economists because the longer-term yields had been so slow to move upwards in recent times. If the Fed Funds target range was to move up this year and next, and if the longer-term yields failed to move, it seemed as if an inverted yield curve was inevitable.

However, after the April 16 move, the yield on longer-term Treasury notes rose and the 10-year/2-year spread remained relatively constant.

The question then becomes whether or not the longer-term yields continue to rise over the next year or so, given the targets set by the Federal Reserve System. The answer seems to be tied up with the future growth rate of the US economy.

If the growth of the US economy remains relatively strong, then the Federal Reserve can continue to stay on its path of interest rate increases and longer-term interest rates will rise as well and the Treasury yield curve will continue to be positively sloped. Given this scenario, the yield on the 10-year Treasury note could rise into the 3.50 percent to 3.75 percent range sometime over the next twelve months.

But, of course, there are other factors that must be considered.

First and foremost, there is the impending impact of the tax reform bill passed by the US Congress in December and the unbalanced budget bill passed earlier this year. Federal deficits are going to rise and this may cause problems for the Federal Reserve System.

The government debt created over the next few years must be financed and the question becomes, what role might the Federal Reserve have to play in helping the federal government finance its debt? Given the increased needs to finance an ever increasing deficit, can the Federal Reserve maintain its securities portfolio reduction plan? How soon might it have to give up the plan?

Of course, there are many other potential disruptions that might occur over the next eighteen months or so. For example, the US economy could dive into a recession, given the length that the current expansion has already achieved.

Another disruption could come about do to a crisis in the Eurozone. What might a new “populist” government do for Italy…and the European Union? Then there is the oil situation with oil prices rapidly rising into the mid-$70s? What about disruptions to oil supplies coming from sanctions on Iran and Venezuela.

Then there is China and the possibility of a trade war with the US, with the possibility of harmful tariffs, and with the coming fight over the treatment of intellectual property.

So far, the Federal Reserve has been carrying out its “normalization” process in a calm, deliberate manner. Hopefully, it will continue to do so. We need to keep our eyes on the Fed and what it is doing because this will tell us a lot of what is happening every place else.

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