The Federal Reserve reduced its policy rate by 25 basis points to a range between 3.75% and 4% on Wednesday and announced an end to the runoff of its $6.58 trillion balance sheet by Dec. 1.
The Fed also reduced the interest rate paid on excess reserves from 4.15% to 3.9% and the interest rate paid in its reverse repo facility from 4% to 3.75%.
We anticipate the central bank will reduce its policy rate by an additional 25 basis points in December and will seek to move back toward the 3% terminal rate over the next two years.
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In addition, the Fed moved to end the runoff of its balance sheet to address liquidity strains at the front end of the market, which pushed the federal funds rate toward the upper boundary of the policy range.
While the Fed expected this would occur, as it draws down its balance sheet despite claims otherwise by Chairman Jerome Powell, we think that the recent move higher in the federal funds rate caught both the Fed and market participants somewhat by surprise.
Liquidity at the front end of the market can be observed in the draining of the Fed’s repo facility and in money markets as banks are using cash to purchase an increasing quantity of short-term securities issued by the U.S. Treasury to fund the federal government’s operations.
But the Treasury is reluctant to increase the issuance of long-term paper because of the probability that investors will demand an increasing term premium, which would send long-term rates higher.
In his press conference on Wednesday, Powell noted that reluctance is one factor that contributed to those liquidity strains and pushed the federal funds rate toward the upper end of its range.
Dueling mandates
As one could observe inside Federal Open Market Committee’s dot plot and Summary of Economic Projections from September, the committee is split around which portion of the dual mandate should receive policy preference: maximum sustainable employment or price stability?
Based on our judgment, price stability precedes sustainable employment; today, the risks are skewed toward rising and persistent inflation as the Fed cuts rates into rising prices and financial conditions that look frothier by the day.
Those two mandates are what underscored the two dissents on the committee: Fed Governor Stephen Miran dissented in favor of a 50 basis-point cut and Kansas City Fed President Jeffrey Schmid preferred no change in policy.
Given the direction of inflation and risks around financial markets, we anticipate more dissents—not fewer—going forward, which in our estimation will capture diverging views on the committee around risks to price stability and maximum sustainable employment.
The statement
The policy statement retained its description of the labor market while indicating that “job gains have slowed“ and the “unemployment rate has edged up but remained low through August.”
In addition, the Fed added that “more recent indicators are consistent” with that increase and that “downside risks to employment rose in recent months.”
The only notation of the government shutdown was the indication that “available indicators” suggest economic activity expanded at a moderate pace and also noted that inflation “has moved up since earlier in the year and remains somewhat elevated.”
Powell also noted the challenges in making policy absent economic data because of the government shutdown but refrained from linking it directly with the upcoming December policy decision.
The takeaway
The Federal Reserve put forward a rate cut as a form of risk management around a slower pace of both hiring and wage growth as firms remain conservative around adding to the workforce and tentatively move away from labor hoarding.
In his remarks, Powell clearly signaled that policy is not on a pre-set course—which, given the twin dissents, reflects the divergence in preference across the FOMC on which portion of the Fed’s dual mandate should be the object of the central bank’s attention.
