January 23, 2023

Our analysis suggests that the Bernanke Fed only did half of the job - it averted the crisis but left the unwinding of the balance sheet to its successors. If we are correct, then he only deserves half of the Nobel Prize and whoever completes the unwinding of the balance sheet deserves the other half if they do it smoothly. We believe that with QT and the management of the commercial paper/fed funds rate spread Jay Powell has the tools necessary to engineer a soft landing. All that is left is for the Powell Fed to execute, and he can clean up the mess that he and his two predecessors created. A reduction in the Fed balance sheet permanently reduces the monetary aggregate, M2, and as a result leads to a decline in the inflation rate. The Fed rate hikes or tightening, the transitory component, alter the relative attractiveness of the excess reserves as well as the reverse repos. The combination or mix of these two policies characterizes the Fed’s balance sheet portfolio management policy. By combining QT with the management of the interest rate spread, the Fed may be able to accomplish its goal of reducing the balance sheet and returning the inflation rate to the 2% range with minimal adverse effect on the economy. The Fed has all of the necessary tools to accomplish these objectives. The repo market is the vehicle the Fed uses to execute its domestic sterilization strategy, but the repo market is not the sole domain of the banking system. Other key players participating in the repo market include money market funds held by mutual fund companies and shadow bankers. In so far as the banks, mutual funds and other money market issuers participate in the repo market, they are substitutes for each other on the demand side. That is, money market holders are able to seamlessly switch from banks to mutual funds and vice versa. This is an important point to make. The money market and the bank excess reserve markets will be linked to each other on the demand side. The Fed balance sheet management strategy introduces a connection between the banks and mutual fund money markets. The implication being that disturbances in one of the markets could easily be propagated to the other market. For example, breaking the buck issues could potentially filter to the banking system. In short, the Fed policy appears to have made contagion among the two markets more likely. This is something that we need to keep in mind.

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