A Postmortem on the Fed’s Tightening Cycle
At the upcoming July FOMC meeting, it looks like the biggest question isn’t whether the Fed will cut interest rates or not, but rather how large the cut will be. As this tightening cycle comes to a close, it’s time to look back on the last three and a half years.
The Janet Yellen-led Federal Open Market Committee raised the target Federal Funds rate by 0.25% in December 2015. That hike marked the official end of a nearly 7 year run at near-zero percent interest rates and the end of an unprecedented easing cycle, but it was not the end of accommodative monetary policy. The cycle would prove to be the slowest sequence of rate increases in at least 50 years.
While the average hike cycle from 1983 to 2006 saw the Federal Funds target (green below) rise about 3.25% over ~1.5 years, this one lasted twice as long, and rates only rose 2.25%. FOMC members didn’t anticipate this outcome. The red line below shows the median expectation for the rate over the longer run, as estimated by the Fed’s Dot Plot. When the first iteration of the dots was released back in 2012, FOMC members thought short-term rates would eventually rise back above 4%. But Fed officials are facing a new reality. The median member now says that at 2.5%, we’ve already achieved the longer-run level.
Of course, the unprecedented nature of the last decade had as much to do with the Federal Reserve’s balance sheet as with the unusually low level of interest rates. After quantitative easing programs increased Fed holdings from about $900 billion in 2008 to $4.5 trillion in 2014, Janet Yellen announced an asset-reduction plan in 2017 with the intention that it would be as slow and boring “as watching paint dry”. The only question since – when the wind-down would end – was answered earlier this year by Jerome Powell. Thus, the second half of this tightening cycle will come to a close in September.
Though the target asset value was obscure, the Fed did an impressive job of forecasting the speed of the balance sheet rolloff. Even though the announcement came with a headline maximum redemption of $50 billion per month, the expected reduction was never that large. Instead, the New York Fed released a forecasted maturity schedule of assets in July 2017, summarized below.
Not a single month was projected to meet the $50 billion cap level, and the average monthly rolloff for the 4 year projection was only $30 billion. The actual asset rolloff has tracked that projection almost perfectly, and the balance sheet will end up somewhere around $3.75 trillion. However, even after a reduction of $750 billion, Federal Reserve assets will still be above the trend established in the decade prior to the financial crisis.
While the Fed has embarked on perhaps its easiest tightening cycle ever, the European Central Bank and the Bank of Japan have kept a foot on the gas. Interest rates in Germany and France are lower than ever, and the BOJ is buying anything it can get its hands on.
It’s worked, sort of. They’ve managed to stave off recessions, but inflation has stayed stubbornly low, and global growth is slowing. Now, easier monetary policy in the United States could undermine their efforts if it results in prolonged dollar weakness. On the other hand, a less restrictive Fed could be enough to reinvigorate the domestic economy and jump-start global growth. Time will tell.
The July FOMC meeting is still a long way away. Earnings, trade news, and macro data could drive voting members towards a 50 bps cut, or alternatively towards maintaining the current rate. A lot can happen between now and then. Stay tuned and have a happy 4th of July.
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