How The Fed Should Manage Its End Game


Fed policy is focused on the wrong factors.

It's not a question of to cut or not to cut.

It's a question of what does the Fed have to do to get its Fed funds rate back in a position to influence market rates again and to be relevant.

Maybe you don’t see the Fed as involved in an end game. Maybe you think that it has just started easing and there is a ways to go. My perspective is different.

In chess, the end game is all important. How it is played determines who wins who loses or if it’s a draw. The end game is the portion of the game played with many pieces having been removed from the board and the two sides usually find themselves playing with different pieces than their opponent has. This is what makes the Fed’s task like an ‘end game’

The Fed has its usual tools but they have become less potent. And compared to other cycles there is less room to cut the fed funds rate. Several FOMC members are playing the game to conserve what ammunition the Fed has left, a classic end-game strategy.

And the Fed is not alone in this predicament. A Reuters poll found that 80% of the economists surveyed were skeptical that the ECB had any ability to influence the inflation rate in the medium term (story) with its policy moves.

The dilemma

In the US, there is a clear policy split. A number of FOMC member do not think that the economy merits a rate cut now. The dispute can be summarized in the views of Eric Rosengren vs. those of Jim Bullard. Rosengren wants to keep the Fed on hold and save its ammunition while Bullard wants a rate cut of 50 bps to catch up with where the markets are, as well as to provide some help for an economy struggling with ongoing trade disruption to the economy.

The Chairman’s take

Chair Powell when confronted, especially at a time when he is being pressured for easier policy by the White House, puts his head down and stays focused on the Fed’s dual mandates. Still, that is not much help as to the direction of policy. Fed members always say they will look at the data and do what is appropriate. We have never before seen so many taking the refuge of being non-committal.

The real choice

The advertised choice is between stimulus now versus later. Some argue to use stimulus now while the economy is still growing; some research says that this is the time stimulus is more effective and the best time to use it if you have little ammunition left. Others want to wait until the economy is faltering, more clearly losing momentum and needy. But is that the real choice? Are those the real issues here? I think not. The real issue concerns what will make policy more effective. And, right now, to directly focus on the economy is wrong. The Fed has allowed market rates to move too far from its fed funds rate, and as a result, it no longer controls market rates with the fed funds rate. This is what the Fed debate should be about. The Fed has lost control and a substantial degree of influence over market rates. And it is only by affecting market rates that the Fed affects the economy, employment and inflation. In short, the Fed attaining its mandate depends on the Fed getting a grip on market rates again. Instead of being properly focused, Fed officials continue to launch discussions focused on the economy and its need for lower rates oblivious to the fact that the FOMC’s decisions no longer affect the things that affect the economy.

Chart 1

Data: Haver Analytics and FAO Economics

In 2019 when the Fed reversed course after softening its language, cutting its guidance and finally cutting rates, the impact on market rates was not just muted, it was perverse.

The constellation of market rates

Chart 2 (below) looks at the spread between the various market rates and the fed fund rate. After the Fed cut rates in late July (effective August 1), the spread of market rates to fed funds actually widened rather than narrowed. The market was essentially telling the Fed that it was moving too slow and that rates were going to have to get even lower. The Fed’s rate cut was only 25 bps and the language accompanying the cut and Chair Powell’s description of the cut in his press conference caused markets to price in lower market rates because the Fed was getting behind the curve. The Fed apparently still does not see this or understand it.

Chart 2

Data: Haver Analytics and FAO Economics

Why wait?

At this point, let’s go back to reconsider Rosengren’s concept using this notion that the Fed losing control of market rates as it surely is. What is the point of the Fed saving its ‘ammunition’ if it is only shooting blanks? If the Fed continues to drag its heels or even resist the market’s move, rates will probably continue even lower. It means that the Fed will lose more control. At some point, if market yields get closer to zero or even go below zero as they have internationally, the Fed could find itself with a high funds rate, market yields below zero or close to it, and with no point to any rate cuts. The point really is to use the ammunition while it still may have power and value.

The real point

Let me repeat that the point of cutting rates is for the Fed to get back in control of market rates instead of being out of control. The lesson here is that even if the Fed cuts rates sharply (50 bps as Bullard urges), it will have to remain attuned to the market’s needs; if it doesn’t, it could lose control again. We are now seeing evidence of central banks making policy in a world where they have less influence. There is no point in them pretending that nothing has changed.

Chart 3

Data Haver Analytics

Role of inflation targeting

In January of 2012, the Fed adopted an inflation target. At that time, inflation expectations began to fall. Inflation had already been correlated around the 2% level and it has averaged around 2% for the headline and core PCE for over 20 years. This is finally sinking in along with the meaning of the Fed’s inflation target. And with a low and more stable inflation rate, interest rates are going to be lower, too. This is something that the Fed apparently did not plan for. Many Fed members are wary of the impact of low rates. But if inflation is low, interest rates will be low too. And inflation expectations are a big reason for it. Too many Fed members seem to be living in the past.

Focus on the impact needed instead of the final goal

The economic situation, or a member forecast for the economy, are not good reasons to hold off on rate cuts if market rates have already lurched off ahead of the fed funds rate. The Fed is not used to being out of control. But it it is and it had better quickly reappraise its situation and use its ammunition while it still works. As for the hawks’ argument that rate cuts may not raise inflation... maybe not. But the point of a large cut would be to get control of market rates again and to make Fed policy ‘matter’ and eventually to use that leverage to make better policy. But if the Fed can’t influence market rates, it can’t make any policy that matters. And that is the bottom line.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.