The good US inflation data we saw last week has investors questioning the Federal Reserve's plans to raise rates to the stated 5%.
From the market movements we've seen since the release of the inflation data, we can tell that the markets don't seem to be particularly interested in exactly where the prime rate will be. It appears to be ignoring the Fed's determination to raise rates, giving the impression that the bank's forward guidance and talk regarding its monetary policy is no longer in effect.
It is possible that the Fed will resort to using other tools in its arsenal to convince the markets of its resolve on financial conditions. For example, reducing the central bank's balance sheet is a likely tool that could be resorted to.
Balance sheet reduction (or the so-called "Quantitative Tightening") is a process in which the central bank releases back to the market securities that it purchased some time ago in order to stimulate the economy.
During the last two crises - the one of 2008 and the Covid crisis of 2020, the Fed bought a huge volume of debt securities (mortgage and government securities), which expanded its balance sheet to over 5 trillion. dollar. US central bankers now face the daunting task of shrinking that balance sheet.
Investors are aware that the US central bank is already nearing the end of its interest rate hike cycle, which is why we may see the first rate cut in 2024.
However, the Fed continues to maintain that interest rates should reach 5% and financial conditions tightened for a longer period of time. Despite hawkish comments from central bankers, the Chicago Fed's index of financial conditions fell to its lowest levels since May 2022.
The markets' latest move against the Fed was a sharp drop in the yield on 2-year US Treasuries, which fell to its lowest level since last October. This shows that investors believe the Fed's 5% target will not be reached despite the assurances.
Against this backdrop, the only option left for the Federal Reserve is to start shrinking its balance sheet more aggressively to keep interest rates high and the dollar strong. In this way, the financial conditions will be sufficiently tightened. The decline in short-term US Treasury yields is a market test of the Fed and how committed the central bank is to keeping monetary conditions tight.
If central bankers are as serious as they say they are, they will soon have to resort to more serious deleveraging from their balance sheets to keep monetary policy tight. Otherwise, they risk losing control of the markets.
If the FOMC members keep the amount of debt securities they market unchanged, it will be a sign that the Fed agrees to the easing of financial conditions, which will give the green light for a rally in the stock markets.
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