Jerry's Dilemma

| February 02, 2024

Fed chairman Jerome Powell's interest rate outlook surprised investors, but I don’t know why. Powell is engaged in a tug-of-war with the federal government. Remember, the Fed has several ways to stimulate or slow the economy. One is by raising short-term interest rates and another is altering the money in circulation by buying or selling securities. Since the invention of quantitative easing (QE) during the Great Recession, the size of the Fed’s balance sheet (and in consequence the money supply) has been unprecedented. When the Fed buys securities, it adds bonds, mortgages, and other instruments to its balance sheet and puts cash into circulation. When the Fed reduces its balance sheet, it removes cash from the economy. The chart below illustrates this.

Assets: Total Assets: Wednesday Level *

Unfortunately for Chairman Powell, the federal government is deficit spending at equally unprecedented rates for peacetime. As The Wall Street Journal points out, even more cash will hit the economy when the IRS finishes “holding back a wave of more stimulus. The agency in September paused processing new claims for the Covid-era Employee Retention Credit owing to concerns over abuse and fraud.” The WSJ also reports that “the Congressional Budget Office says the federal deficit was $509 billion in the first three months of the current fiscal year, which is 21% larger than during the same period in the prior year.” **

Federal Debt: Total Public Debt as Percent of Gross Domestic Product ***

This tug-of-war between the Fed and the government explains Powell’s pause, pun intended. The Fed’s very deliberative assessment of what is prudent is set against the murky and scattershot policies of the federal government during an election year.

At this point, the Fed will have to cut rates somewhat. They may also slow down the reduction in the balance sheet. Whether or not this will cause a resurgence is inflation is unknowable right now, but unless a recession comes out of nowhere, the near-zero interest rates that the market expected seem off the table. However, with China slowing, global supplies increasing, and supply chains improving, I would not be surprised by three rate cuts by next year.


* https://fred.stlouisfed.org/series/RESPPANWW#

** The Editorial Board. "The GOP’s Spending Boost for Biden Booming federal outlays are providing a short-term lift to GDP." The Wall Street Journal, Online, February 01, 2024. https://www.wsj.com/articles/gdp-economy-jerome-powell-government-spending-federal-reserve-1e1ddfc3?mod=opinion_lead_pos1. Accessed on 02.01.2024.

*** https://fred.stlouisfed.org/series/GFDEGDQ188S#