March 08, 2023

It is interesting to note how much a single inflation observation has impacted the financial markets and people’s expectations about the economic outlook. But is this change in expectations justified? Does the recent higher inflation measure reflect a change in the inflation rate’s downward trend? Or does the higher inflation read reflect a random variation around a downward trend? Is it random or a reversal? These possibilities yield vastly different outlook implications. Exploring them is a worthwhile endeavor. The RRPs surge during the Pandemic was largely due to the financial backstop produced by the Fed that it did not want monetized. However, these funds could easily become part of the monetary base. All the RRP holders have to do is liquidate them at maturity and they will receive greenbacks that are part of the monetary base. Hence the RRPs are sort of the monetary version of the sword of Damocles. And that is what we worry about. While the Fed does have some control as it can alter its interest payment, its control is not absolute. This is a vulnerability of the Fed’s RRP policy. If people stop buying the RRPs, the monetary base and possibly the inflation rate could increase dramatically. Under these conditions, in order to prevent the people from liquidating their reverse repos the Fed would be forced to pay much higher interest rates on the RRPs. Which brings us to the issue of whether the Fed will successfully engineer a reduction of its temporary OMO portfolio without adversely affecting the inflation rate and/or short-term interest rates? Time will tell.

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