Money Markets and the Federal Reserve – by William Campbell (July 2019)
Posted: Monday, July 29, 2019

Fixated on Federal Reserve interest-rate policy, the risk markets could be missing 90% of the monetary iceberg: the Fed’s $3.8 trillion balance sheet and the more than $3.3 trillion U.S. money market. A decade ago, the central bank embarked on so-called quantitative easing (QE), bond-buying on a colossal scale to flood the banking system with excess reserves and avert a meltdown of the financial system. Now, with the U.S. economy showing years of continued improvement in employment, the Fed has reduced excess reserves. This effort at policy normalization is tightening financial conditions. Such quantitative tightening (QT) is at odds with recent signals by the Fed of its intent to ease official short-term interest rates. This policy divergence poses two threats. First, QT could choke off credit just as the U.S. is entering an economic slowdown, raising the odds of recession. Second, QT could derail the Federal Funds rate as an effective monetary lever. Indeed, signs of “Fed Funds” losing its efficacy are already appearing in the overlooked but vital money markets. In fact, money market rates could decouple from Fed policy actions. Such a development would jeopardize market confidence in the Fed’s ability to transmit monetary policy to markets, threatening a major risk sell-off.

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