Traders Start Looking for a Fed Rate Cut Later This Year

Danielle DiMartino Booth, CEO & Chief Strategist at QI Research, examines the balance between inflation and labor market risk as questions grow about the future of Fed leadership.

Fixed‑income markets are overestimating the impact of potential changes to the Federal Reserve’s balance‑sheet policy, which are likely to be slow and limited, according to Canadian Imperial Bank of Commerce.

The Fed isn’t likely to start shrinking its $6.7 trillion balance sheet until next year, said CIBC’s strategists Michael Cloherty, Arjun Ananth and Ian Pollick. Even then, the US central bank would not sell holdings of assets like mortgage-backed securities to avoid spooking the market. It would also rollover roughly a third of its Treasury holdings, they said.

Policymakers have debated ways to reduce one of the main drivers of the balance sheet’s growth: the banking sectors’ demand for cash held at the central bank. Dallas Fed President Lorie Logan said last week she favors using changes in liquidity rules to shrink banks’ need to hold reserves, following similar calls from Governor Stephen Miran and Vice Chair of Supervision Michelle Bowman.

A recent essay published by the Dallas Fed about ways the central bank can shrink its balance sheet understates the costs and risks of a rapid balance sheet reduction, said the CIBC strategists.

There are also some underlying issues that “aren’t immediately obvious,” they added. For starters, proposals like lowering bank reserves or offering tiered rates on bank reserve policies, would increase the importance of money-market funds in the transmission of monetary policy. The funds have been the primary vehicle for transmitting monetary policy to the market by through the Fed’s overnight reverse repo facility.

That shifts some control over monetary policy actors to the Securities and Exchange Commission, which oversees mutual funds, from the Fed, they said. That could limit the banking regulators’ reach during a crisis.

“In times of extreme stress it can be useful to have strong regulatory control over the firms you are relying on for monetary policy passthrough,” they wrote.

CIBC thinks the Fed is unlikely to adjust either interest on bank reserves or the offering rate on the reverse repurchase agreement facility, which means the forward spread between the Secured Overnight Financing Rate and interest on excess reserves is “a little too wide,” and the markets are mispricing short-term rates. A growing number of Federal Reserve officials worried the Iran war could further stoke inflation and wanted to make clear following their March meeting that the central bank may have to consider raising interest rates.

Minutes of the Federal Open Market Committee’s March 17-18 meeting, released Wednesday in Washington, showed policymakers wrestled with starkly differing scenarios for the US economy following the outbreak of the Iran war, and the policy reactions that might follow.

Most officials worried a protracted war could hurt the labor market and warrant lower interest rates. At the same time, many policymakers highlighted the risk to inflation that might ultimately warrant rate increases. Stephen Stanley, chief US economist at Santander Capital Markets, said the minutes showed the committee saw risks rising for both inflation and employment, and wary of what a longer war may mean.

“A protracted conflict, not the baseline, could further exacerbate both of these risks,” Stanley said in a note to clients. “This left the FOMC firmly on the sidelines.”

Officials who expressed more worry about inflation urged their colleagues to consider adding language to their post-meeting statement that raised the scenario of hiking rates under certain conditions.

“Some participants judged that there was a strong case for a two-sided description of the committee’s future interest-rate decisions in the post-meeting statement, reflecting the possibility that upward adjustments to the target range for the federal funds rate could be appropriate if inflation were to remain at above-target levels,” the minutes said.

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