Key Highlights

• The Fed’s expected rate cut next week will occur in an environment of higher-than-target inflation
• Taylor rule suggests rates should be over 5%, but the Fed is clearly concentrating on the employment objective of its mandate
• September could pose challenges to funding markets, but the Fed is confident

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Raising rates while inflation stays hot: Rules were meant to be broken

EXHIBIT #1: IS THE TAYLOR RULE RELEVANT? 

_{Source: BNY Markets, Bloomberg}

After the disappointing payroll data last week, along with a number of other weaker growth-related data releases, expectations for a Fed rate cut next week are essentially locked in. Indeed, current market pricing sees a greater than 100% chance of a 25bp reduction in the federal funds rate, indicating a nonzero chance of a 50-point cut. Furthermore, the expectations for additional rate cuts at each of the two remaining meetings in 2025 after the September FOMC are close to 100%. We find it hard to disagree with this pricing at present (although we don’t see a jumbo cut next week), but we also wonder what a renewed easing cycle means for inflation and, ultimately, longer-term rates.

Inflation data, in the form of the August CPI and PPI releases, will be released later this week, and expectations are that annual inflation will be around – or even slightly above – 3%. What does this mean for the Fed, its perceived inflation-fighting credibility and the market reaction to a series of rate cuts in the face of high or rising inflation even while the labor picture weakens? Our fear is that we could see the market come around to the idea that the Fed is – at least temporarily – eschewing its inflation target in service to the employment component of its mandate. Concerns about the central bank’s independence also add to the potential perception that the Fed will let inflation run hot.

A straightforward rules-based estimate of appropriate policy-setting reveals some interesting counterpoints to the idea that rates need to come down. The Taylor rule uses current deviations of inflation and employment from their long-run targets and proposes an optimal policy rate given the central bank’s dual mandate. Interestingly, using current values for core PCE inflation and the unemployment and the “longer-run” values for both expressed in the most recent Summary of Economic Projection as the Fed’s targets, the Taylor rule suggests that the nominal federal funds rate should be 5.2%, well above its current 4.5% and its likely 4.25% rate after next week’s FOMC.

Exhibit #1 shows the actual federal funds rate versus the standard Taylor rule implied rate over the last decade. Note that during the early days of the pandemic, the implied rate was much lower than the actual rate. Since nominal interest rates are bounded by zero, a rule-implied rate of less than zero indicates quantitative easing is appropriate, as indeed was the case at the time. However, once inflation began to rise in 2021 and remained elevated in 2022, the Taylor rule indicated that rates should have been much higher than they actually were. All of this suggests that rules-based monetary policy models don’t conform to actual policy choices, something we chalk up to the overly simple and rather static construction of these rules.

However, it also suggests that the Fed – if it follows through with easing this autumn – will be placing more weight on the employment shortfall than the inflation overshoot.  This could be because the Fed thinks the inflation overshoot will be short-lived – the result of what it sees as a one-time (but not all at once) increase in prices that comes with higher tariffs. This further suggests that – at the moment at least – the Fed is placing higher priority on the impending employment shortfall. We’ll likely see the central bank cutting rates while inflation hovers around or slightly above 3% (and possibly accelerating), and short-term inflation expectations that are quite elevated (see Exhibit #2). This is, to state the obvious, a somewhat unusual state of affairs.

EXHIBIT #2: INFLATION EXPECTATIONS STAY ELEVATED DESPITE LOOMING RATE CUTS

_{Source: BNY Markets, Bloomberg}

What this does to the Fed’s medium-term credibility is something we’ll have to gauge by observing the reaction of the longer end of the U.S. Treasury curve. To be sure, the 10y yield has fallen to just above 4% after the weak jobs data, reflecting the idea of lower policy rates as the Fed’s response. Interestingly, the term premium on the 10y note has not fallen commensurately, and it is still at levels that have prevailed since April this year. This suggests that the perceived riskiness of lending to the government at long horizons has not receded, but the expected short rate has fallen.

September and the money markets

System-wide bank reserves are now at their lowest level since early February, something we expected as T-bill supply (up by over $600bn since early July) increases and the reverse repo facility continues to shed assets – now down to around $20bn per day. Still, at just under $3.2tn, there is no obvious concern that reserve levels are “too low” or that repo stress is imminent. Nevertheless, September could be a tricky month for funding markets, as it marks quarter-end, features a large increase in bill settlements and includes the September 15 tax date, all of which could further drain reserves.

In a speech in Mexico City on August 25, Dallas Fed President Lorie Logan addressed balance sheet and funding market issues and expressed confidence that with its current tools in place, including the standing repo facility (SRF), the month could pass without severe ructions in the money markets. She did concede that this month “could see some temporary pressure around the tax date and quarter-end in September.”

Nevertheless, she pointed out that with generic repo rates well under the rate of interest paid by the Fed on bank reserves, money is not tight in the funding markets, so while the particularities of September may be somewhat challenging, the current setup of the Fed’s liabilities (RRP, reserves and the Treasury General Account) and market demand for funding is sustainable – at least in the short term: “In the U.S., repo rates have averaged about 8 basis points below interest on reserves in recent months. That tells me we have more room to reduce reserves.”

However, this speech is now over two weeks old. It is true that at the time it was delivered, the spread she cites was indeed appreciably negative. However, since then it has narrowed to nearly zero (see Exhibit #3). This sort of narrowing is not unprecedented in the post-COVID landscape and typically happens at quarter-end periods, as can be seen in the chart. However, the data in the chart run through the end of last week, just the first full week of the month – not yet close to the end of the quarter. 

EXHIBIT #3: NARROWING SPREAD BETWEEN IORB AND REPO

_{Source: BNY Markets, Bloomberg} 

We have pointed out previously (see here) that in proportion to U.S. nominal GDP or as a percentage of total bank assets, reserves are still not close to as low as they were in mid-September 2019, during the now-infamous repo market crisis and the need for Fed intervention. Even if things get tight in September this year, Logan points out the existence of tools like the discount window and the SRF will help fill any breach in the funding markets. The SRF was used at the end of Q2, the first time it was tapped in a meaningful way. The Fed is confident that these tools – despite fears around any stigma associated with their use – is an important component of interest rate control and funding market stability.

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