Forget Rate Hikes! Fed Chair Kevin Warsh Can Raise Interest Rates Using 2 Nontraditional Methods.
Wall Street and investors were privy to a bit of history two weeks ago. The Federal Open Market Committee’s (FOMC) July 28-29 meeting marked the first time in 56 years that three FOMC members dissented so early in the tenure of a new Fed chair.
Although the Federal Reserve held interest rates steady at 3.5%-3.75%, three members favoring a quarter-point rate hike suggest how pressing an issue inflation is at the moment. This historic dissension also sent the Dow Jones Industrial Average (DJINDICES: ^DJI), S&P 500 (SNPINDEX: ^GSPC), and Nasdaq Composite (NASDAQINDEX: ^IXIC) on quite the ride.
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While there’s a very real possibility that Fed Chair Kevin Warsh and his FOMC colleagues will undertake a rate-hiking cycle to stabilize prices, the Fed chair and policymakers have two nontraditional methods they can employ to raise interest rates without adjusting the federal funds target rate.
Removing forward guidance can influence the bond market
To begin with, Warsh’s removal of forward-looking guidance from FOMC meeting statements appears to be having a clear impact on interest rates.
For more than two decades, it’s been customary for the central bank to include forward-looking guidance (i.e., an easing, neutral, or tightening bias) in FOMC meeting statements. While this guidance provided transparency in the equity and bond markets, it also constrained policymakers’ responses, according to Warsh.
Beginning with his first FOMC meeting as Fed chair in June, Kevin Warsh axed forward-looking guidance. Removing this transparency from Wall Street’s plate is likely to make the bond market more cautious when inflation is well above or below the central bank’s long-term target of 2%.
With inflation running hot at the moment (a three-year high of 4.2% in May and 3.5% in June), bond traders have been pushing up yields at the long end of the Treasury yield curve. The 30-year Treasury yield reached a 19-year high, while the 10-year yield isn’t too far from accomplishing the same feat.
Higher yields at the long end of the curve can increase borrowing costs and provide the same/similar effect of a traditional FOMC rate hike.
Deleveraging the central bank’s balance sheet can boost interest rates
Another way that Kevin Warsh and his colleagues can influence interest rates without formally adjusting the federal funds target rate is through deleveraging the Fed’s balance sheet.
During Warsh’s testimony before the Senate Banking Committee on April 21, he criticized the central bank’s bloated balance sheet, which grew tenfold between August 2008 and March 2022 to nearly $9 trillion. As of Aug. 5, the central bank held $6.75 trillion in assets (primarily long-term Treasury bonds and mortgage-backed securities).
The new Fed chair would prefer the central bank to be a passive market participant, which would entail meaningfully paring down this asset portfolio.
Keeping in mind that bond prices and yields are inversely related, selling trillions of dollars in U.S. Treasury bonds could quickly move the needle. Selling pressure would be expected to weigh on bond prices, push up long-term yields, and make lending costlier.
Whereas Warsh has been able to effect change in the bond market by removing forward-looking guidance, he’ll need the support of his colleagues to shrink the Fed’s balance sheet. But if he’s successful in garnering support for this deleveraging, the FOMC can meaningfully boost bond yields without a traditional rate hike.
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Forget Rate Hikes! Fed Chair Kevin Warsh Can Raise Interest Rates Using 2 Nontraditional Methods. was originally published by The Motley Fool