Monthly Macro with Richard de Chazal—September 2024

In this episode of William Blair Thinking Presents, macro analyst Richard de Chazal discusses the Federal Reserve’s 50-basis-point rate cut and its implications for future monetary policy. He explores the factors behind this decision, the muted impact of the recent tightening cycle, and what it all means for the economy moving forward

Podcast Transcript

00:20
Chris
Hello, everybody. It's September 25th, 2024. William Blair macro analyst Richard de Chazal and I are back again for a new episode of Monthly Macro. This time to focus entirely on the Fed's 50 basis point cut in rates. Richard welcome back.

00:36
Richard
Thanks, Chris.

00:36
Chris
The Fed kicked off its easing cycle with a bigger cut than many were expecting. It seems like 25 basis points was the strong message from the Fed leading up to the cut and then we got this 50 basis points surprise instead. What happened? Why the surprise change?

00:51
Richard
Yeah, definitely, a bit of a surprise given the messaging we had from the Fed ahead of this meeting. So, I mean, typically, the Fed does a pretty good job on the forward guidance front. And by the time the actual FOMC meeting normally rolls around, the outcome is pretty much a foregone conclusion. So it's all sort of done and dusted.

And you know, it's sort of just a formality. You know, when the Fed sort of tells us actually what happens on that day, this time I think they probably got the messaging or obviously did get the messaging a bit wrong about wanting 50 and not 25. The market clearly understood 25. So I think they were forced to very unusually, during the blackout period, leak to the press that 50 was still on the table, which obviously meant that they actually wanted 50, or else why bother making that announcement? So a bit of a bit of a poor communications job there, which they'll have to go back and review and assess what happened.

But why 50? I think the simple answer is that the Fed sees the economy slowing but not collapsing. It sees that the inflation risks have really diminished and inflation is pretty much now back on target or, you know, very close to target. So as the Fed has been telling us, that pendulum has swung from inflation as being the risk, now towards over-tightening and causing unemployment to rise too quickly. And I think the Fed also knows that, you know it's starting at “point A” here, so between five and a quarter and 5.5%. And it has to get to “point B” even though it doesn't actually know how far ahead that “point B” is or where that terminal rate is. But it does know it's probably, I don't know, 150, 200 basis points, 250 basis points lower than where we are today. So, you know, why not jump start that a little bit and you know, cut by 50, which is actually not very unusual at all when the Fed starts these, easing cycles in the past.

So, what I don't think it was, was some sudden panic, you know, that the Fed is worried about some banks or a hedge fund, or is it a banking system that's about to collapse? Something like that. I think it just knows that if it doesn't start to act soon, policy is going to continue to tighten, particularly as inflation comes down. So that real rate has been rising and continuing to tighten, and it just wants to get ahead of that, and it wants to increase the chances of actually getting that soft landing.

3:49
Chris
Make sense. In your note that immediately followed the cut, you mentioned that there shouldn't be an expectation that the size of cuts will continue. Why is that, exactly? And what are your expectations?

4:00
Richard
I think it is basically that. We know that they have to go lower than where they are today on rates. So let's get ahead of that process. But I think where they end up is the really big question that we’re continuing to ask. And I'm still of the view that rates will probably have to come down maybe to the 2.5 to 3% level, which I think is roughly the neutral rate. And that's actually what the market is pricing in right now with a terminal rate of just below 3%. But actually, if you listen to a lot of the commentary, you know, on TV or, you know, on Twitter, in the press, a lot of people are saying that you know, no, no, no, it's actually closer to 4% and the market's getting it wrong.

I don't think so. So I think for context, maybe it's worth thinking about if you look at past economic recessions, rates have fallen by about 500 basis points in a recession period. And, you know, over the last few recessions, you've also had to do QE on top of that.

So I think in a soft landing scenario where you're cutting by 200, 250 basis points from where we are today, I think that's still consistent with where the neutral rate is. And a soft landing where that policy rate is neither restrictive nor accommodative. So, I would say that, in my mind, it seems pretty sensible.

5:34
Chris
And moving on to your economics weekly from last Friday, you talked about how this past tightening cycle could have been much worse. And then you question whether the conditions that muted its impact might also be obscuring the assessment of the economy's real neutral rate of interest, the r-star, as you say making it seem much, much higher than it actually is. Let's dig into that a bit, starting first with what you deemed the partly sterilized QT assessment and the Fed’s strategy of offsetting the reduction in security holdings, which, they did by sharply reducing the amount held in money market funds that are held in the Fed's overnight reverse repo account.

6:14
Richard
Ya. it’s a mouthful. I think we do have to talk about the Fed’s balance sheet and what’s been going on there and how QE and QT, or quantitative easing and quantitative tightening actually work. I think it's probably fair to say that in a “normal QT environment,” in a normal QE environment, quantitative easing, that's basically where the Fed buys treasuries or asset backed securities from the market and credits those entities with reserves held at the Fed in the Fed's bank account.

So it's basically a creation of this thin air money and the idea being that, the yields on that debt go down. You know, the banks are now stuffed with reserves, looking for a place, you know, for yields with the cash that they have. So they get pushed further out along the risk curve. The so-called portfolio channel effect, which then adds liquidity to the market and should help the economy get moving again.

So that's the QE side. QT, you know, in theory, well, sort of in theory because we don't have a lot of examples of QT. But in theory, you would think it should be the reverse of that. So the Fed, it doesn't actually ever sell off the debt on its balance sheet, but it allows the Treasury debt to roll off. So the asset side of its balance sheet shrinks as those roll off. And then that has to be matched on the liabilities side, as you would expect with reserves coming down which basically get extinguished. So the opposite of the QE. And that happened for a while during this, recent QT period, but basically, right up to the start of the regional banking crisis, if you remember Silicon Valley Bank, which was not that much not that long ago, but feels like it.

08:28
Chris
It does feel like a century ago.

8:31
Richard
A lot has happened since. So, you know, basically since then banks started to hang on to their reserves after that and those reserves actually started to rise again. So the Fed, you know, it's actually reduced its balance sheet since the start of QT by $2 trillion. But bank reserves, which you would expect to go down have only fallen by $11 billion, so basically nothing. And that means that something else has to adjust on its balance sheet. Either some assets on the balance have to increase or something else on the liabilities have to go down to match that QT roll-off.

And so, you know, what's been taking up the slack, and I think it's obviously been the decline in this overnight reverse repo account. And what's that? That's basically a facility the Fed set up that sucks liquidity out of the market when it feels like there's too much liquidity out there, which might prevent it from raising short-term interest rates off the floor when it wanted to do that. And it can also add liquidity back into the system when the money in that account is coming out and falling.

9:51
Richard
And it's basically an account where the Fed is swapping treasuries on its balance sheet for cash that's held by a wider group of financial entities. So some shadow banking things in there. But I think for simplicity, let's just call it money market funds, because basically that's a lot of what it is. Then the Fed basically takes cash overnight and pays those funds an interest rate on that cash.

So which is attractive because it's a risk, totally risk free yield there. And what's crucial about this is that when the Fed takes that money and puts it on its balance sheet, it's effectively taking that money out of the system. It's sort of parking it, on the sidelines, on the bench, which means that that cash then can't be used for leveraging, you know, in the system to invest in other riskier assets.

And what's happened over the last year or so, has been that as short-term interest rates have moved higher, money market funds have been attracted to those rates. So they've been taking that money out of the Fed's balance sheet and bringing it back into the financial system to get yields on the back of that, which is actually creating liquidity in the system.

So you basically had two liquidity enhancing things happening while the Fed's been doing QT. The first is that bank reserves have stayed quite plentiful. So they haven't been sort of destroyed as you'd quote unquote normally see. And two, money coming out of that overnight reverse repo account has also been additive to the system. So both of those, I think, have been helping to sterilize the impact of that QT, or at least partially sterilizing it.

And I think it's possible, though, that the Fed is worried that going forward, with the amount of money that's now come out of that reverse repo account, you're now back to pretty low levels. So there's not a lot more money or liquidity being added to that.

That neutralizing effect will start to disappear. And you might actually have QT doing a lot more unsterilized tightening than was happening before.

So that's potentially, I think, one reason maybe the Fed is quite keen to get rates down because the tightening is kind of done its job. It really doesn't need to do more. And you know more could potentially happened if you get more unsterilized QT as it were.

12:45
Chris
You also bring up Operation Twist. You've explained this in past episodes as a process. The Fed has officially adopted twice in the past to provide balance sheets for the economy, while also keeping the size of the balance sheet unchanged. How did this strategy play a role in offsetting the Fed's tightening this time around?

13:03
Richard
Ya I think that's exactly right. The Fed in the past has done an operation twist and that's when it tries to manipulate longer term bond yields lower, but then not doing that by purchasing more from the market. It's allowing shorter term debt to roll off and reinvesting that back, into the longer end of the yield curve to kind of twist that, twist that yield.

So that's on the demand side, the Fed side. But I think what we actually saw this time around was on the supply side where Janet Yellen, who remember, you know, was at the Fed during the Operation Twist episode. So maybe she at the Treasury thought, hey, you know, maybe the Treasury can do something similar this time around.

So instead of issuing more longer term debt, we can boost the supply of shorter-term treasury, which could help to reduce longer-term bond yields or prevent them from rising more. And I think that's basically what we saw. We've seen a big increase in short-term Treasury debt issuance as opposed to longer-term and actually shorter-term debt issuance, again, is also liquidity enhancing to the market because that can be used for collateral chains and all sorts of things there. So I think the Treasury, you know, was effectively gambling that there's strong demand right now for T-bills and because money is coming out of those money market funds, you know, longer-term debt issuance wasn't very popular, you know, over the last year because the market felt a little bit uncomfortable about rates and that was, you know, pushing, interest costs higher. So, you know, let's issue more short-term debt. And when it comes to twisting back to a more balanced, you know, longer term, we can assume that inflation's going to be lower. Growth is going to be slower from the Fed's tightening. And the Fed will also be cutting rates, so longer-term yields will start to come down. And if that's what they were thinking, you know, she's been exactly right. So you know, in that twist process, she's also, I think, helping to reduce the restrictiveness of the Fed's tightening.

So, I think that's what some market participants were getting a little bit, you know, commenting on. That, you know, they were doing this in an election year. So maybe that was, somewhat controversial. Some economists like Nouriel Roubini and Stephen Mirror wrote a paper recently on this. And I think, you know, Yellen surprisingly actually commented on that. And she very strenuously denied that that's what the Treasury was doing. You know, they're saying they're basically definitely not trying to manipulate the yield curve let alone have any impact on the election.

But I think the fact is that you just look at the numbers. And T-bill issuance has risen quite significantly, relative to coupon issuance. And, you know, the other fact than is, is that early next year, the Treasury has to twist back. So we're going to see coupon issuance increase quite substantially. And, you know, that should put more pressure on the long end of the curve.

And I guess my point is, is that once again, it's possible from the Fed's perspective that they're looking down the road and they're maybe again thinking, you know, we need to start easing policy now. We need to get ahead of this other potential further tightening from debt issuance. And this is definitely not something that Powell was talking about and would surely deny.

But I think it's possible that that’s something, you know, that has to feature in the Fed's thinking because it does line up with the fact. So, I think, again, that Operation Twist has had this sort of on the Treasury side, a bit of a neutering effect on the QT. And if that's ending, then presumably the opposite happens.

17:47
Chris
Corporates and consumers also played a key role in keeping the economy relatively healthy during these past few years of tightening. Which you, of course, go through in the report. Can you walk through that a bit?

17:59
Richard
Sure. I mean, I think I think it's basically the same thing here. It's basically that maybe that tightening or the tightening we've seen hasn't been as restrictive because both households and the corporate sector locked in these really low rates in 2020 and 2021. So you know, it's probably the case that, many households haven't really felt too much of that impact of tightening.

So even though mortgage rates are up or went up to sort of 7 and 8%. I think they're down 6.5% now. The effective mortgage rate that most people are paying has been around 3%. But again, the risk going forward, and Fed is very aware of this, is that people start to roll off those low mortgage rates.

They can't stay on them forever. You know, life happens. They need to, you know, move or whatever. And they do need to start paying higher rates going forward. So even though the Fed is bringing rates down, people are rolling into higher rates and the corporate sector as well. They need to refinance. We have maturity walls coming up in 2025 and ‘26.

And the Fed is again thinking about maybe these lagged effects are in the pipeline. And they'll continue to tighten policy. So you know maybe the Fed is again trying to get ahead of that. And maybe that’s what they were considering with a 50 basis point cut.

19:30
Chris
So what does this all mean for the terminal rate in your view?

19:32
Richard
That's the huge question at the moment. Where are we? Where are we going? You know, where is that neutral rate and, you know, that rate is the rate where policy is not restrictive, is not too accommodative. But just right. It’s the Goldilocks rate. And unfortunately, we don't know where it is. So it's not you know, the market thinks it's basically 3%. The Fed thinks they've just increased their estimate, to 2.9%. And I think that's, that's probably, about right. Again, some people are saying no, no, no, it's up near 4%. And the market is really, overestimating how low rates are going to have to go in this cycle. And my point is that you know, maybe actually the market is right.

And maybe, you know, for that reason that we're just talking about maybe rates weren't quite as restrictive as they could have otherwise been. And maybe it wasn't just the economy is so strong and so resilient. Maybe it was more, you know, because of sterilized QT, Operation Twist, you know, consumer and corporate balance sheets. And it maybe it's not so much that the real potential rate of GDP growth has suddenly jacked up from, you know, 2.5% to 4%, which is really what objectively drives this r-star real rate.

And maybe the Fed is again concerned about this. So, you know, it's not necessarily 4% it maybe just brought rates high. Maybe the restrictiveness isn't as much as it thought and going forward, as those factors sort of unwind, we're still going to get some tightening following through. So once again, I think the Fed is potentially trying to get ahead of that and maybe not as convinced as the market, or not the market, but a lot of talking heads are that policy rates won't have to be cut all that much.

Many people are looking back to basically, we've had three soft landing periods and the last one was in ‘95 where the Fed only cut 75 basis points. And I think people are saying, oh, okay, that's the template. Well, that's only one episode. And I think this time around they're going to end up having to cut much more than that.

22:15
Chris
All right. Well, that's all the time we have for today, Richard. I'll chat with you again next month. Have a great one.

22:20
Richard
Look forward to it. Thanks, guys.