Ear to the ground
The Fed must rely on the data and not its policy framework to curb inflation.
The cautious and shrewd way Federal Reserve policymakers communicate can put diplomats to shame. But the success of their decisions in the coming months will depend upon how well they listen.
Managing monetary policy in the midst of a global pandemic has been, and remains extraordinarily difficult. No one can deny that. But the Fed’s response to mounting inflation in the last several quarters showed it wanted to stick to its new paradigm in the face of facts. If you recall, in August of 2020, it recast its policy framework to allow inflation to exceed 2% as long as the labor market is strong. Officials not only viewed rising prices in 2021 as “transient,” but also a positive after years of undershooting 2%.
While telegraphing 50 basis-point hikes in the next two FOMC meetings, minutes from the last meeting and recent official speeches suggest the committee might pause to assess their impact. In other words, they will—and should—return to making decisions based on data in the fight against inflation without inducing a recession. Policymakers have to listen to what the economy is telling them on a scale much smaller and a timeframe much shorter than they prefer. This is no time for long-view academic studies.
Reports already indicate that this economy might be more responsive to shifts in monetary policy than traditionally expected. The housing market, consumer outlook and industrial production are cooling off. It is not unreasonable to think that supply-chain bottlenecks and energy prices exacerbated by China’s shutdown and the war in Ukraine could improve by the fall. Data dependency is a cliché that completely applies here.
What of investors? The bond market seems to be declaring victory over inflation and the stock market is betting on the worst-case scenario. Investors in the short end of the Treasury yield curve are acting more rationally, although the supply/demand imbalance, especially in the front end, has caused it to trade much lower in yield.
In addition to the supply/demand imbalance, the flight-to-safety trade has depressed Treasury yields further. You have to go to the 6-month section of the curve to find yields above the Fed’s Reverse Repo Facility. But money managers able to use the facility are benefiting from the rate hikes. It is currently offering 80 basis points—higher than yields found in the open market overnight.
Investors should be recognizing this soon, and acting. While flows into money market funds were essentially flat in May across the industry, we expect them to increase soon. This would follow the plot of the last rate-hike cycle of 2015-18, when it took several months for investor flows to migrate into money funds.
The main difference this time is that the magnitude of the hikes are larger based on inflation-fighting in addition to normalization. While most funds have short average maturity ranges now, they tend to lag the direct market immediately after a rate increase by a larger amount but for a shorter time period. Yields on prime instruments and municipal issuance are a different story, with both offering attractive spreads over Treasuries. Contrast this with deposit products. Administered rates have not budged much because banks still are flush with cash and don’t want deposits—especially now that the cost of lending is increasing. The money markets are in a good place, and a good place for investment. Cash is an asset class again.
Despite the concerns in May about market disruptions based on cryptocurrency pricing challenges and sales of collateral, the types of high-quality securities permitted to serve as direct investment as well as collateral in the high-quality short-term markets were unaffected.
In light of the anticipated rate hikes, we kept the weighted average maturities (WAMs) of all our money funds in a target range of 25-35 days in May.