Will News from the Fed Heat Up the Markets?

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jan 30, 2019 12:22:45 PM

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FedWith the brutally cold weather locking down large parts of the country, the hope today is that the Fed will heat up the markets by both holding rates steady (as expected) and dialing back the liquidation of its balance sheet. Personally, I think investors should be careful what they wish for. If the Fed really does slow the quantitative tightening process, in conjunction with keeping rates steady, it could be a sign of an even colder economy ahead.

Right now, the Fed is doing two things. First, it is raising interest rates in a slow, measured way to keep the economy growing but not overheating. Second, it is slowly withdrawing the excess money it injected into the financial system during the crisis. The first action is what the Fed is supposed to be doing, but the second is a reversal of an emergency measure. They are two very different decisions and give very different signals to the markets.

“Patient” on rates

Think about it. If the Fed keeps rates steady, as expected, it is simply doing what it has said: being patient. It doesn’t preclude later increases, depending on the data, and is in line with market expectations. In fact, with the government shutdown, it makes sense to take a break and see how the damage stacks up. This is prudent monetary policy and not a signal of anything worrying.

Balance sheet drawdown: return to normal?

On the other hand, the drawdown of the Fed’s balance sheet (i.e., the quantitative tightening process) is supposed to be on “autopilot.” While raising and dropping rates is a normal part of the Fed’s operations, the initial quantitative easing was an extraordinary measure taken because of a crisis. The reversal of that, now underway, represents a return to normal and the end of a crisis policy. That’s why it is on autopilot—it is supposed to be a return to normal. If the Fed interrupts that process, you have to wonder if things are maybe not as normal as everyone now believes.

The Fed has been working to return monetary policy to normal because, when the next recession hits, it will need a full toolbox to deal with it. Slowing that process, by slowing the drawdown of the balance sheet, only makes any future recession policy harder. It would raise the possibility that when a recession hits, the Fed might not be able to act as forcefully as needed.

Watch the signals

Put those pieces together, and a significant change in the balance sheet policy would signal two things: that perhaps the economy is weaker than markets think and that, given that weakness, the Fed is deliberately dialing down its ability to deal with it. This would be a worrying signal over the medium term.

In the short term, this change would probably be perceived as positive and drive rates down slightly on the expectation of continued dovishness. The reality, however, is that it would both be a negative economic sign and a negative policy sign.

The other option is that the Fed continues with its existing drawdown policy. Markets would likely not be too happy in the short run, but this would signal both that the economy continues to expand at a reasonable rate and that we are still getting closer to normal, which is what we need to see.

Please hold your applause

Watch what the Fed says about the balance sheet. Changing the final target balance is fine—the Fed has to. Changing the composition of the balance sheet, by getting rid of mortgage securities, also makes sense. But slowing the drawdown in any significant way is something to worry about—not cheer.

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