The Federal Reserve building in Washington
The Fed’s focus on raising short-term rates has resulted in ‘yield curve inversion’, a market aberration where short-term borrowing costs are higher than long-term rates © Reuters

The writer is a former chair of the US Federal Deposit Insurance Corporation and a senior fellow at the Center for Financial Stability

The US Federal Reserve should feel vindicated in its decision to pause rate rises at its policy-setting meeting last month. Alas, it seems poised to raise them again. Forgive the cliché, but this risks snatching defeat out of the jaws of victory. For now, the Fed should stay put and hold rates where they are.

Climate change may be leading to stifling temperatures, but US inflation is cooling. The consumer price index rose a mere 3 per cent in June, down sharply from a peak of 9.1 per cent in June 2022. The rate of producer price increases slowed even faster.

Stubborn increases in the costs of shelter and services have significantly slowed. And a separate analysis by Morgan Stanley of raw data taken from new leases shows residential rents actually falling in some cases. Meanwhile, the economy remains robust. Unemployment is at 3.6 per cent. June brought with it 200,000 new jobs. 

These trends provide hope that inflation can be meaningfully reduced if not defeated without choking off the economy, so long as the Fed does not overshoot.

Over the past 15 months, the Fed has tightened at a staggering pace. It has lifted rates from near zero to north of 5 per cent. By April, a common measure of money supply, M2, had dropped 4.6 per cent year over year, the biggest decline since the Fed began formally tracking M2 in 1959. The economy needs time to adjust to these seismic shifts in monetary conditions, particularly given that the Fed kept rates near zero for 14 years.

The economy seems to be adjusting — so far — but there are several shoes still to drop. Trillions in corporate and commercial real estate have yet to reset to higher rates, but will need to refinance over the next few years. Households still benefit from cash cushions built up during the pandemic, but will be feeling the full bite of higher borrowing costs once those funds are gone. While the labour market remains healthy, private sector job growth has slowed notably.

Labour and small business are at particular risk if rapid rate increases cause further banking distress. This in turns adds pressure on regional and community banks.

The Fed’s primary focus on raising short-term rates has resulted in “yield curve inversion”, a market aberration where short-term borrowing costs are actually higher than long-term rates. If this persists, it represents an existential threat for smaller banks with profits that depend on their ability to use short-term deposits to make longer-term loans at higher rates.

If the Fed does raise rates again — as seems certain at this week’s meeting of the policy-setting Federal Open Market Committee — it could temper the impact by only raising rates on bank reserves, while leaving the rate it pays to money market funds and other non-bank financial intermediaries where it is.

Using new tools handed to it by Congress in 2008, the Fed can increase the interest it pays banks on their reserve accounts when it wants to raise rates. This gives banks an incentive to keep their reserves at the Fed unless they can achieve a higher, risk-adjusted return by lending them out.

In 2013, without Congressional authorisation, the Fed created an “overnight reverse repo facility” — the functional equivalent of a reserve account for non-bank intermediaries such as money market funds — which pays rates almost as high as those paid on bank reserves. This similarly gives non-banks an incentive to keep money sitting idle at the Fed.

While ONRRP was meant to be limited and temporary, it has in fact ballooned into around a $2tn facility, contributing to financial instability by draining deposits from banks. 

Lowering the yield on ONRRP relative to the Fed’s target rate should cause money market funds to redeploy some capital out of the facility and into investments that meet the credit needs of our economy. This would mute the contractionary impact of another rate rise, while contributing to bank stability as much of that capital would find its way back into bank deposits.

The Fed faces difficult choices, but we know further tightening heightens the risk of recession and financial instability. If it does continue to tighten, it should find ways to temper the impact. Just as the Fed misjudged the inflationary risks of its loose money policies, it should not now underestimate the potential impact of the jaw-dropping pace of its tightening. The safest choice is to stay put.

Copyright The Financial Times Limited 2023. All rights reserved.
Reuse this content (opens in new window) CommentsJump to comments section

Follow the topics in this article