Fed may only have hit neutral now

Introduction

The objective of most central banks is to maintain price stability. They use monetary policy tools to achieve this. These include:
1. The reserve requirement.
2. Policy rate.
3. Open market operations.
The Fed wants to decrease aggregate demand and prices, given the current inflationary environment. To achieve this, it is implementing a contractionary monetary policy. In this article, we focus only on the policy rate.

Policy Rate

  • This federal funds rate is the benchmark rate set by the central bank.
  • It is effectively the rate at which banks lend money to each other.
  • A critical factor in policy rate adjustments is the neutral interest rate. I.e. the rate that neither increases nor decreases the economic growth rate.
  • It is typically estimated by adding a central bank's inflation target to the real trend of economic growth.
  • The complexity is that the trend rate is an estimate and is in flux as economic conditions change.
  • However, let us assume an inflation target of 2% (average inflation target aside) and a growth rate of 2%.
  • This gives a neutral rate of 4%.
  • Interestingly, yesterday's 75bps hike only now brings us to this neutral range.

A policy rate above neutral is, in effect, a contractionary monetary policy. Given that the Fed may only have just hit neutral, the Fed's hawkishness is understandable. Chair Powell admitted as such, saying that "the level of interest rates will...be higher than previously expected."

Transmission Mechanism

The policy rate transmission mechanism has four channels:
- Market interest rates: raising the policy rate has made interbank borrowing and lending more expensive. Therefore commercial banks have increased their short-term rates to compensate, decreasing aggregate demand. Credit is more costly, and business activity has fallen.
- Asset values: bond and equity prices declined as discount rates in valuation models moved higher. This lowered the wealth of investors in these instruments. Savings became more attractive, and consumption dipped.
- General sentiment: higher rates have hurt confidence, and businesses and consumers are more pessimistic about the future. As a result, they've cut down on spending, looking to add to savings to help in difficult times.
- Currency rate: the higher rate has caused the USDOLLAR to appreciate as capital flowed towards the greenback as the choice for saving. Imports of foreign goods and dollar-denominated commodities are cheaper, helping to offset inflation.

Conclusion

Given the transmission mechanism and that the Fed may only now have an impact, the four channels may still be adjusting. If so, asset prices may still be under pressure, and the USDOLLAR still supported. However, for a pivot to be sensible, we think there needs to be a noticeable moderation in the median inflation series.

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Russell Shor

Senior Market Specialist

Russell Shor joined FXCM in October 2017 as a Senior Market Specialist. He is a certified FMVA® and has an Honours Degree in Economics from the University of South Africa. Russell is a full member of the Society of Technical Analysts in the United Kingdom. With over 20 years of financial markets experience, his analysis is of a high standard and quality.

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