Pity Jerome Powell. The chair of the United States Federal Reserve has just been called a bonehead by his boss. Now he faces the unenviable task of explaining the Fed’s latest interest-rate decision to increasingly baffled investors, while dealing with the aftermath of an unexpected squeeze in short-term funding markets.
The cost to borrow cash overnight using what are known as repurchase agreements, or repos, briefly surged fourfold late Monday, raising questions about whether the Fed is firmly in control of money markets. The Fed calmed markets on Tuesday by injecting more than US$50-billion into the U.S. financial system, but the episode added to concerns about the direction of central bank policy.
Most observers figure that Mr. Powell and his colleagues on the Fed’s Open Market Committee will cut the central bank’s key federal funds rate by a quarter of a percentage point, to between 1.75 per cent and 2.0 per cent, when it wraps up its two-day meeting on Wednesday. But what has many investors perplexed is why.
Recent readings on the U.S. economy have come in better than expected. The Citi Economic Surprise Index, which measures whether economic data are beating expectations or falling short, has jumped into positive territory as gauges of retail sales, industrial production and housing starts have surpassed forecasts. Unemployment remains unusually low while stocks continue to hover near record highs.
The better-than-expected readings on the economy would ordinarily suggest this is not the time to stimulate activity further by cutting interest rates. But the actual data don’t seem to matter now. “The Fed is no longer data-dependent,” Joel Naroff of Naroff Economic Advisors wrote in a note. “What it is depending on is anyone’s guess.”
Cynics will argue that Mr. Powell and the rest of the Fed’s Open Market Committee are yielding to pressure from the White House. U.S. President Donald Trump used his Twitter feed a week ago to lambaste the “boneheads” at the Fed for not dropping interest rates to zero. Maybe, too, the Fed is afraid of disappointing stock market investors, many of whom have already pencilled in a rate cut.
A more flattering theory is that the Fed intends to buffer the economy from the uncertainties created by the U.S.-China tariff war and the attacks on oil facilities in Saudi Arabia. This could make sense, except that it is unclear how the Fed or anyone else can quantify the risks involved in either situation.
Some signs suggest trade tensions are easing. Mr. Trump recently postponed planned increases in tariffs on Chinese goods, while China lifted punitive tariffs on U.S. soybeans and pork. Chinese negotiators are supposed to arrive in Washington in early October for further talks.
Meanwhile, oil prices fell back on Tuesday after reports suggested the damage from the drone attack on Saudi infrastructure might be less severe than originally thought.
But nerves are on edge, and the squeeze in short-term funding markets between Monday afternoon and Tuesday morning added to the tension.
Repo markets are a key channel through which some large borrowers obtain short-term cash by selling U.S. Treasuries to investors then pledging to buy them back the next day. Repo markets seized up during the financial crisis, indicating deeper problems in the financial system.
This time around, more mundane problems are likely to blame. U.S. corporate tax payments, which were due on Sept. 15, probably contributed to the repo turmoil. Companies pulled cash out of money market funds to pay their taxes, reducing the supply of dollars in the system, according to many observers. A recent raft of new bond issuance by the U.S. Treasury may have further sapped the supply of cash on hand.
The Fed’s injection of money into the system quickly reduced repo rates to more normal levels on Tuesday, but has left some analysts wondering if such problems could reappear if the Fed continues to reduce the size of its balance sheet, reducing the amount of bank reserves available for short-term payments.
“We think that the culprit is the scarcity of bank reserves, which are the only asset that provides banks with intraday liquidity,” TD Securities said. “Reserves have been declining since 2014 and we expect them to decline further.”
On top of that, there is the continuing uncertainty over which way the economy will veer. A month ago, the global economy appeared to be slowing rapidly and the futures market put the chance of a super-sized half-percentage-point rate cut at 32.7 per cent. Now, with more optimistic data on hand, the probability of such a big cut has receded to a mere 13.6 per cent. The chance of a more modest quarter-percentage-point reduction has grown to 86.4 per cent.
Further rate cuts are also looking more unlikely. But trade tensions, Middle East drone attacks and a fragile repo market make it difficult to know which way the Fed will jump next. Investors will be looking to Mr. Powell for a fuller explanation.