Monetary Policy Changes

This week’s FOMC decision was not an easy choice. Our goals are in conflict. Inflation is above target, the labor market is softening, and there are risks to both sides of our mandate—maximum employment and price stability.   Two charts explain why I ultimately favored a rate cut.   The first shows the damaging cost of high inflation. It has chipped away at real earnings and weakened household purchasing power. Many Americans are still trying to catch up.    So, the FOMC must continue to bring inflation down. Anything other than 2% is not an option. But it matters how you get there. This means we cannot let the labor market falter.   Real wage gains come from long and durable expansions. And the current expansion is still relatively young, as shown in the second chart. Holding policy too tight can cause undue harm to American families and leave them with two problems: above-target inflation and a weak labor market.   Congress gave us two goals. And our job is to meet both of them. The recent policy decision puts us in a good place to achieve that.

This macro variable will tell us when the music is about to stop. High interest rates are supposed to break something because an overly indebted economy will have to service a mountain of debt at expensive rates and it will have less money for income and spending. The problem is that people are looking at the ''wrong'' debt. Private sector debt levels and trends are far more important than governmment debt. Contrary to the government, the private sector doesn't have the luxury to print money: if you get indebted to your eyeballs and you lose your ability to generate income, the pain is real. As Dario Perkins' left chart shows, the biggest financial crisis happened as a result of high and growing private sector debt.  The Japanese or Spanish house bubble bursting, the Asian Tigers, or China today are clear examples. So, where does the US stand on this important macro metric? The chart on the right shows how US private sector debt as a % of GDP sits well below the ~200% dangerous line, and it has rapidly declined since 2008. In the US, government fiscal stimulus are supporting income and consumption while households and corporates are reducing leverage from their balance sheet. The AI debt-driven capex cycle will reverse this dynamics, as corporates lever up to spend big and position themselves in the AI race. It's only when private sector debt increases rapidly that one should begin to really worry about a bubble burst. What do you think? 👉 If you enjoyed this post, follow me (Alfonso Peccatiello) to make sure you don't miss my daily dose of macro analysis.

It's no secret that I have been expecting a 50 basis point rate reduction at the upcoming FOMC meeting (September 18). Here are a few additional thoughts ... The Fed can either decide to tighten financial conditions or not. The futures market is currently pricing a 59 percent probability of a 50-basis point rate cut. Thus, unless something changes, going 25 will tighten financial market conditions, pushing interest rates up. Monetary policy works through the financial markets. Tighter financial conditions should be avoided when the balance of risks between growth and inflation have shifted as they have now. If the downside risks to employment outweigh the upside risks to inflation, then the Fed should be leaning against tightening financial conditions, all else equal. What are the chances of a hawkish 50 basis point cut? Powell may be successful in pushing through a 50-basis point rate reduction, but the projections show only a total of 75 basis points of rate cuts for the entire year. That would imply officials see only one more cut for the year, a hawkish sign. I am skeptical this will matter in the end. A “hawkish 50” is as unlikely as a “dovish 25.” In the former case, the dots will not be that significant. Powell will use the press conference to downplay them and stress these are conditional estimates. I am always reminded of what Yellen said back in 2014: “I think that one should not look to the dot plot, so to speak, as the primary way in which the Committee wants to or is speaking about policy to the public at large.” This is one reason I think going 50 or 25 is important. A popular argument goes like this: because many cuts are priced into the market the size of the move this week is not that important. I get it but believe this understates the significance in a few important ways. For one, the Fed’s policy rate is linked to prime rates. It’s the Fed’s rate not expectations that determine small business loans and auto loan rates, for example. Next, a big upfront move is a signal that the Fed means business about getting back on sides while a 25-basis point move with rates still far from neutral implies they are willing to leave a restrictive policy in place for a long time. 

Project Pine explores how central banks could implement #monetarypolicy using #smartcontracts in a fully tokenized environment (where money and securities exist as #digitaltokens). Its question is whether central banks could effectively implement monetary policy using smart contracts in a future where money and securities may be tokenized with the purpose to test how current central bank operations could adapt if tokenization were widely adopted. The project developed and tested a prototype “smart contract toolkit” for central bank operations such as paying interest on reserves, conducting open market operations, managing collateral, and purchasing or selling assets. A generic and customizable smart contract toolkit was developed to support core monetary policy operations: ➡️ Paying interest on reserves (including tiered and real-time interest) ➡️ Conducting open market operations (repos, swaps, outright purchases/sales) ➡️ Collateral management (eligibility, haircuts, substitution, valuation) Testing Approach and Simulation through a simulated a range of historical and hypothetical stress scenarios (liquidity shocks, bond market collapses and reserve scarcity and abundance) in which agents (e.g., commercial banks) autonomously interacted with central bank smart contracts. 🔹 Technical and Operational Findings: ➡️ The toolkit proved to be flexible, fast, and effective, with smart contracts responding instantly to changes in conditions with the prototype meting all functional requirements, including simultaneous operation of multiple tools and dynamic parameter changes. ➡️ Central banks could quickly deploy new facilities, change interest rates, and issue collateral calls, even during crises. ➡️ Use of trusted time oracles (e.g., central banks) helped avoid inefficiencies found in trustless public blockchain systems. However, the report emphasizes that the benefits of tokenization for central banks depend heavily on context. For central banks already operating highly efficient systems, gains may be incremental. Moreover, central banks would require special privileges in tokenized systems—such as trusted oracle status and enhanced data access—and must manage heightened privacy and cybersecurity risks. Project Pine also highlighted that smart contracts must be custom-built to reflect central banks' unique operational needs, since existing DeFi solutions are often unsuitable. Project Pine is a collaborative research initiative by the Bank for International Settlements – BIS Innovation Hub Swiss Centre and the New York Innovation Center of the Federal Reserve Bank of New York: https://lnkd.in/dFs8vXKb #payments #regulation #risk #liquiditymanagement #risk #dlt #smartcontracts #tokenization Prasanna Lohar Sudin Baraokar Nafis Alam Sam Boboev Panagiotis Kriaris Nicolas Pinto

Fed Day July 2024. The Fed should start its path back to normal in July by cutting the federal funds rate. The progress already made on inflation justifies a first cut. Personal Consumption Expenditure (PCE) inflation is within ½ percentage point of its target, while the federal funds rate remains more than three percentage points higher than before the pandemic. The outlook for inflation and the lags in monetary policy strengthen the case further to begin a gradual easing. The recent cooling in the labor market and the possibility of significant weakening are not necessary to justify a cut, but they are risks to consider. True that there is no apparent urgency to cut this week—economic growth and the labor market remain strong—but that’s not a reason to wait. Good monetary policy doesn’t hold off for urgent circumstances. Good policy is forward-looking and balanced; as inflation normalizes, so should the Fed. Reality check. Will the Fed cut in July? No. Will they make it sound like a September cut is as likely as markets think it is? No. I expect the FOMC statement to be read as hawkish, and then Powell will soften the blow some in the press conference. Even so, some hawkish aftertaste will probably remain. More on Substack. #federalreserve #inflation #FOMC https://lnkd.in/enN4HzCh

Bringing out the Big Guns:  The Fed is about to enter an easing cycle that will prove supportive for Private Equity. While PE sponsors do not hibernate like bears in the winter, sponsors have been quiet from an acquisition/exit standpoint since the past two years have proven difficult given equity valuations and higher financing costs (SOFR rose +525bps). Ditto for perspective homeowners who have bemoaned the fact that home prices/mortgage rates/operating costs make ownership less attainable. But relief is coming. Looking forward, I expect SOFR to gradually decline by 200bps in the next two years as the Fed eases and inflation normalizes. Other considerations will come into focus for LBO sponsors: 1) potential for higher corporate tax rates, 2) changes in supply chain cost structure derived from nearshoring and tariffs, 3) slower economic growth, 4) regulatory scrutiny from FTC and EU that impacts (e.g. technology, healthcare) and 4) valuations have risen to all-time highs. Despite this, PE is sitting on $1.2T of undrawn capital globally. $1.2T of dry equity powder with lower future financing rates as lenders are willing to provide a dollar of debt for every dollar of equity. During the past two years, PE has focused on value creation with add-on acquisitions, revenue growth, improving operating metrics, technology investment, CapEx, streamlining costs, improving margins all to minimize/offset higher interest charge. By and large, PE has performed admirably despite the higher interest rate regime, and slower deployment/exits. Going forward, I expect greater exits plus dividend recaps to return capital to LPs. The average LBO PE-multiple is 12x EBITDA with stapled financing of 6x debt-to-EBITDA. LBOs on the rise, the lull coming to an end, the big guns are out and ready for hunt.

After reading a lot of “hot takes” on inflation, I realized a few things are worth underscoring. A Top 10 List 1) The Federal Reserve made no commitment to cut rates at the March meeting; Chair Powell underscored that every meeting is live - the Fed thinks they are at a peak in rates but could change their mind. 2)The Fed revised up its forecast for growth (a lot) inflation (a bit), revised down its forecast for unemployment (a bit.) To reflect those shifts, it the pace at which it expects to cut rates in the medium term. (2024-2026) 3) The median forecast is for three cuts in 2024 BUT the number of people expecting to cut two or less rose; rate cuts in subsequent years are less. The neutral (non inflationary) rate also moved up (a bit.) 4) The Fed is managing risks. It is balancing the risk of cutting rates prematurely against holding rates too high for too long and causing an unnecessary recession. The Fed would rather quell inflation by slowing the pace of cuts than raising unemployment rapidly. 5) Powell said every meeting is live. Nothing is set in stone in terms of the course of policy, let alone direction, until we get closer to what looks like price stability. Lags in policy suggest the Fed moved when it approached but has not yet reached its goal. 6) The Fed would not hesitate to hike again if inflation gets stickier. 7) Powell reminded us that the Fed could and has moved between meetings; it would not hesitate to change policy in a crisis. 8) An acceleration in employment (or growth) alone is not enough to make the Fed resume rate hikes; it could be accompanied by a rise in productivity, which would alleviate the upward pressure on prices. 9) The Fed is not the enemy of wage gains but is concerned that wages may be rising faster than needed to achieve price stability - wages are growing faster than inflation, which is restoring purchasing power. Productivity is the elixir that enables us to keep more of what we earn without stoking inflation. 10) We could be close but are not yet at an inflection point in policy. This is when monetary policy is more nuanced and more of a art than a science. It is also when consensus tends to break down and more dissenting votes express their concerns - Powell made a point of welcoming the debate as it is healthy - within the Fed it is usually, although not always been respectful. Bottom Line: Normalizing rates after a bout of inflation is not the same as cutting to stimulate a moribund economy. More broadly, central banks are concerned that global fragmentation, climate change, armed conflicts and geopolitical risks have left us more susceptible to supply shocks and bouts of inflation. That could require more activists monetary policy to dampen inflation and raise the risk of more volatile business cycles. We’re not in Kansas anymore.

The #FederalReserve (Fed) held interest rates steady for the fourth consecutive time today, signaling a dovish stance. While two rate cuts are still projected for later this year, they are not guaranteed and depend on economic data. The Fed is monitoring signs of labor market weakness and external risks like tariffs and geopolitical conflicts, which could be seen as price shocks rather than inflationary pressures. Inflation expectations have remained contained, and leading indicators suggest some economic softness. Easing monetary policy without a recession tends to be positive for risk assets, making this meeting potentially bullish for markets.

Although the FOMC as a whole is still pricing in 3 rate cuts for 2024, while asset markets are discounting in 1-2 cuts, there is an increasing number of Fed officials who are either bluntly or subtly hinting that their individual base case is for 0 rate cuts in 2024. Credit markets are in better balance now, given we are no longer pricing in 6-8 rate cuts, but there is still a possibility that the outcome for interest rates is still more hawkish than currently priced in.