What Did The Federal Reserve See That We Missed?
On Wednesday, March 19, the Federal Reserve Open Market Committee made its latest decision on interest rates: “Steady as she goes,” said the Fed, a succinct decision that led to one of the shortest Fed statements in recent memory.
Fed Chairman Jerome Powell reported the committee’s latest assessment of the economy: “…economic activity has continued to expand at a solid pace,” and “The unemployment rate has stabilized at a low level.” The only note of caution was echoed in the comment: “Inflation remains somewhat elevated.” (CPI at 2.8% versus the Fed’s Goal of 2.0%).
https://www.federalreserve.gov/newsevents/pressreleases/monetary20250319a.htm
Altogether, this is as close to a “Goldilocks” scenario as you’re likely to hear from the Federal Reserve: economic growth and employment are doing well, and there is just a touch too much inflation. It naturally follows that the Fed left interest rates unchanged. Why mess with a good thing?
But then the Fed went on to say something completely out of character, a complete disconnect from what had gone before: the Fed voted to lower the rate at which it is “retiring” its Balance Sheet from $25 billion to just $5 Billion. This is especially odd, given that a reduction in Fed liquidity would also help reduce inflation.
Something strange is going on here. Let’s work our way through this.
Another principal way that the Fed helps manage the economy is through a process that’s become known as “Quantitative Easing (or Tightening).” You may recall that we heard this term a lot back during the COVID-19 Pandemic. Back then, the Fed used QE to add liquidity to the banking system.
The mechanics of QE work like this: To add funds to the financial system, the Fed buys US Treasury Securities, placing the Bonds and Notes on its balance sheet while providing money to the Primary Dealer System, which is on the other side of the transaction, the “sellers,” if you will.
The Fed has used this strategy extensively since the Great Financial Crisis of 2007–09. But it really went into high gear during COVID-19; when the dust cleared, the Fed had almost $9 trillion in bonds, notes, and other US Treasuries on its books.
For the past three years, the Fed has tried to sell those bonds and “redeem” them, as they say in this latest Fed Statement. But you may ask: won’t that reduce liquidity in the system? Yes. You’re absolutely correct; this is Quantitative Tightening (a term you’ll never hear the Fed use). Taking money out of the financial system, remember each bond is repurchased (redeemed) from those same Primary Dealers, and lowering their balance sheets.
QT, then, reduces overall liquidity and economic activity, slowing the economy. In addition to slowing the economy, QT would also reduce inflation, and we all thought that was the principal aim of the Federal Reserve. But the Fed goes on to say that they’re NOT holding to their redemption (QT) Schedule of $25 Billion. Instead, they’re going to LOWER redemptions dramatically to just $5 Billion. They’re taking their foot off the inflation break. Strange.
It’s likely that the Fed sees something they don’t want to talk about, something that’s making them cautious about the current outlook for the economy.
Indeed, a lot is going on over 1600 Pennsylvania Avenue. President Donald Trump has put a lot into motion, much of which reverses the highly stimulative policies of the prior Administration. The DOGE Program is laying off substantial numbers of Government workers, which will have a chilling effect on the economy, particularly in Washington. The deportation of illegal immigrants could potentially reduce the number of consumers by millions. Reducing government spending is a drag on Fiscal Stimulus.
Additionally, the Fed must look to its restrictive policies. Significant changes in monetary policy can impact the economy long after they’ve been instituted. It’s been just 18 months since the Fed halted its dramatic increase in interest rates (from essential zero to 5.5%). It’s conceivable that the full impact of that interest rate hike is still working its way through the system as consumers and businesses adjust to this new higher-rate environment.
Finally, all of this has caught the attention of a group of researchers in Georgia. The Fed’s own Atlanta Branch shocked the investment world in February when it dropped its GDP growth projection to a negative 1.5%, later lowering the number to a negative 2.8% (since revised to negative 1.8%).
The Atlanta Fed does not attribute this decline in projected GDP growth to the “main office.” (I wouldn’t either if I wanted to keep my job!) Instead, they point to all the results of the current Quantitative Tightening: lower manufacturing, lower auto sales, and even lower employment.
Of course, this is a highly dynamic situation with the economy constantly changing. The Atlanta Fed tracks all this in the GDP Now model, which is updated just about every week. But one thing we can be sure of is that the Federal Open Market Committee saw something they didn’t like, and the result was that they reduced their QT (“redemptions”) by 80%. It may take weeks before we find out definitively what caused that change, but it likely wasn’t good.
My Dad always said: “Watch what they do — not what they say.”
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