"The Rate Hike That Will Crash the System"
by Brian Maher
"Mr. James Bullard presides over the Federal Reserve Bank of St. Louis. He fears the inflationary flames presently fanning. He wants to get good water on them: “The current policy rate is too low by about 300 basis points," he argues. That is, the policy rate should approach 3.50% - rather than today’s 0.50%. Can the Federal Reserve attain this 3.50% target without flooding Wall Street… and Main Street? Artificially low interest rates keep both dry as can be.
Here we yield a hint: The Federal Reserve cannot attain this 3.50% target without flooding Wall Street and Main Street. At what point must the Federal Reserve kink the hoses and dispatch the lifeboats? Please select your answer:
A): 1%
B): 2%
C): 2.50%
D): 2.75%
Have you taken your guess? The answer - revealed shortly - hides within the “shadows.” Today we drive a penetrating light through the murk… and illuminate the answer. First the fundamental facts, the skeleton facts…
Steering Blind: The federal funds rate is the interest rate the Federal Reserve influences directly. It presently ranges between 0.25% and 0.50%. Traditional models calculate this rate’s gravitational exertions upon economic conditions… whether it pushes… or pulls. Lower rates are believed to push. But how can they give additional push at the zero boundary? They cannot.
The Federal Reserve roughhoused rates down to zero after the Great Financial Crisis — and again during the plague year. In both instances the Federal Reserve was hot for more stimulus than zero rates could yield. They found their answer in quantitative easing. In 2020 the Federal Reserve undertook quantitative easing in quantities truly astounding, quantities that shamed all previous easings. Economists lacked the models to discern quantitative easing’s gravitational effects. Thus the economics world slipped into a sort of netherworld, an unmapped wilderness where all familiar reference points fell away.
Analyst Michael Lebowitz in summary: "The Fed conducts monetary policy via manipulating the fed funds rate. In 2008, when the rate hit zero, the Fed wanted to do more. Unwilling to lower rates below zero, they introduced quantitative easing, or QE. QE effectively lowers rates by buying Treasury and mortgage securities. The reduction of supply leads to higher prices and, therefore, lower interest rates and yields.
Before 2008 we could measure how aggressive monetary policy was by comparing fed funds to measures of economic growth… Since the birth of QE, the [models] do not paint a complete picture of monetary policy. To do that, we must factor in QE and the effect it has on interest rates." What was quantitative easing’s effect on interest rates?
The Answer Is in the Shadows: University of Chicago Booth economists Jing Cynthia Wu and Fan Dora Xia were out for answers - to penetrate the blackness at the zero bound… and to get light in. Here is the question they raised: Can we develop an interest rate model that accounts for quantitative easing’s loosening effects? They furled their sleeves, chained themselves to their desks and burned barrels of midnight’s oil… hunting answers.
In 2014 they barreled through the zero boundary and its inky mysteries. They illuminated the “shadow rate.” As one observer explains the shadow rate: "When the federal funds rate hovers near zero, many economic models stop working. Researchers developed a “shadow rate” that can stand in for the fed funds rate, drop into negative territory and make those models functional again."
The Bills Will Soon Come Due: “The pace of QE or QT can be combined with the headline federal funds rate to calculate a shadow federal funds rate,” explains Zero Hedge, adding: "So combining the expansion of the Fed’s balance sheet from sub-$4 trillion at end 2018 to almost $9 trillion was the equivalent of the federal funds rate falling to minus 5%." That is, the headline rate had been zero or near zero. Yet mix in the $5 trillion of quantitative easing. Now sink into the shadows… and you have a shadow rate of negative 5%.
Now come home, to the present day. The Federal Reserve plans to drain its balance sheet from the present $9 trillion to $6 trillion. If quantitative easing dragged the shadow rate down - to negative 5% - how high will quantitative tightening push the shadow rate? The Federal Reserve has vastly reduced its quantitative easing. Meantime, it has elevated the federal funds rate by 0.25%.
Into the Shadows: Now come into the shadows. The March rate increase may be listed officially at 0.25%. Yet the shadow rate suggests a much greater tightening. SocGen “quant” Solomon Tadesse calculates the 0.25% rate increase… was in fact a 2.50% rate increase.
Thus the shadow rate has leapt from negative 5% to negative 2.5%. Zero Hedge, by way of emphasis: "But now that the Fed has reversed, ending QE combined with just one 0.25% hike in the headline federal funds rate, means the shadow FFR has already jumped from minus 5% to minus 2.5% - a 250-basis-point hike."
The Federal Reserve is likely preparing a 0.50% rate increase in May. It likewise plans aggressive drainings of its balance sheet. Thus the shadow rate would jump into light, into positive space. The Federal Reserve evidently seeks a 3.5% federal funds rate. Yet when the shadow rate is considered, 3.5% is not far distant. SocGen’s crackerjacks believe the Federal Reserve will be forced to abandon its target long before it plans.
And so we return to our earlier question: At what federal funds rate must the Federal Reserve quit the tightening - before it lays waste to Wall Street and Main Street alike? Again, your choices are:
A): 1%
B): 2%
C): 2.50%
D): 2.75%
Drumroll…Here is your answer: A. The Federal Reserve will be forced into retreat once the headline federal funds rate scales 1%.
Zero Hedge: "[This] latest analysis for this cycle puts the peak of the fed funds at just below 1.0%, or less than three more rate hikes before the Fed is forced to reverse!" Affirms SocGen’s Albert Edwards: "The actual federal funds rate will struggle to get to 1% before the Fed needs to halt the tightening cycle. That is shocking."
We must agree. It is shocking. Yet it is not surprising. It merely indicates the exquisite fragility of a financial system constructed of gossamer. How have we arrived at this sad, sad pass? The aforesaid Mr. Michael Lebowitz: "Without extremely low interest rates to make the new and existing debt affordable, economic growth would disappear, and financial defaults would be plentiful. The Fed must believe they must help Congress worsen the nation’s fiscal imbalances versus dealing with the problem in a sustainable manner. Expediency at tomorrow’s cost, once again, seems to be winning the day… Hiding such actions under the guise of appropriate monetary policy seems to be their modus operandi."
Just so. Expediency at tomorrow’s cost won yesterday. It wins today. And we wager our last dollar bill that expediency will win tomorrow…Expediency at tomorrow’s expense… forever and ever… world without end…Until it does end."
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