Federal Reserve's Unconventional Gamble: Reserves, Not Economy, Drive Rate Cut and Quantitative Tightening Decisions
The Federal Reserve's decision-making, particularly regarding rate cuts and quantitative tightening, is primarily driven by the availability of reserves rather than the state of the economy. The shift towards a more dovish stance in December can be better understood by considering the role of central-bank reserves at the base of the liquidity pyramid.
Central-bank reserves, crucial for market functioning, have become even more pivotal in the post-GFC era due to changes in their volume, velocity, and ownership patterns. The key constraint for the Fed this year is the level of reserves, acting as a frontline defense against potential risks such as a significant decline in risk assets or dysfunctional funding markets.
Contrary to the common perception that rate cuts indicate a deteriorating economy, a cut in rates might be driven by the need to address reserve-related concerns rather than economic downturn signals. The liquidity environment in 2023 was relatively stable, but the falling reverse repo facility (RRP) and the increasing government interest rate bill pose upcoming challenges to liquidity.
A negative feedback loop, where falling markets impact economic confidence and vice versa, could be triggered by a less favorable liquidity backdrop, potentially leading to a recession. The Fed's strategy to mitigate this involves supporting reserves, particularly by addressing headwinds from the rising government interest bill.
The recent drop in the ten-year yield, resulting in lower interest costs for the government, aligns with the Fed's pivot in December. This implies that the Fed's primary reaction function is based on managing reserves, with inflation and employment being secondary considerations.
Investors should pay close attention to the volume, velocity, and ownership distribution of reserves when gauging the Fed's decisions on rate cuts and quantitative tightening. As the RRP approaches zero, the total volume of reserves becomes a greater concern. The velocity of reserves is influenced by government interest payments, and the distribution of ownership among a few large banks can also impact market dynamics.
Despite the current level of reserves and discussions about slowing quantitative tightening, the Fed's focus on reserves presents a significant gamble, assuming that inflation will moderate back towards the 2% target. However, various factors, such as supply constraints, rising wage indicators, and a substantial fiscal deficit, suggest potential challenges to this assumption in a paradigm of increasing fiscal dominance. In this context, central-bank independence has eroded, giving way to a form of "reserve dominance" in decision-making related to rate cuts, quantitative tightening, and broader economic and market dynamics.