The Federal Open Market Committee (FOMC) released its latest monetary policy statement.  It was widely expected that the Federal Reserve would cut rates, but there was a question of how much.  I thought the Fed would cut by 25 basis points.

The Fed issued a 50 basis point cut to its targeted federal funds rate.  This will drive down short-term market interest rates.

Some are going to call this the Kamala rate cut.

The annual price inflation rate according to the government statistics is 2.5%.  The Fed’s statement said, “Inflation has made further progress toward the Committee’s 2 percent objective but remains somewhat elevated.”

The statement also reads, “The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run.”

A few years ago, the Fed was talking about averaging 2% inflation, but didn’t really specify a time period.  With the high price inflation we have seen over the last several years, it seems the Fed should be trying to get price inflation under 2% for several years to make up for what we have recently had.

Is the Economy Strong?

Yet, the Fed is cutting its target rate by 50 basis points (0.5% interest).  This does not seem consistent.  What seems logical is that we are right before an election, and a cut in rates would seem to benefit the incumbent party by boosting the stock market and economic activity, even if it may lead to higher prices in consumer goods down the road.

The reason I thought the Fed would only cut 25 basis points is because the Fed likes to be predictable.  In addition, a cut of 50 points could backfire, as it could end up signaling panic to the market.  Stocks zoomed higher after the Fed announcement, but the rally was short lived.  If anything, this could be a signal that the Fed officials think the economy is far weaker than what they are publicly saying.

This will also help de-invert the yield curve, which is what we are likely to see before we see a recession.  The 10-year yield is now higher than the 2-year yield, and the short-term yields are moving lower faster as compared to the long yields.  In other words, the yield curve is flattening out.

Still Deflation

There is an even bigger inconsistency with this whole thing.  The Fed is lowering rates, which indicates a looser monetary policy.  Yet, the Fed is still engaging in monetary deflation.

According to the Implementation Note, the Fed will continue to not roll over some maturing debt.  In total, it will continue to allow $60 billion per month to expire ($25 billion in Treasury securities and $35 billion in agency debt and mortgage-backed securities).

This is a total disconnect from how the Fed operated before the fall of 2008.  In the old days, the Fed would generally get lower interest rates by issuing new debt (i.e., expanding the money supply).

Now, the Fed controls the federal funds rate by changing the interest rate paid on reserve balances.  In other words, the Fed pays banks money to keep funds parked with the Fed.  This controls the overnight lending rate between banks, which is the federal funds rate.  This is what everyone is talking about when they talk about the Fed cutting “rates”.  It is really the federal funds rate, which again, is controlled by the Fed’s rate paid to banks for their reserves.

So, we have a conflicting policy of the Fed lowering rates while simultaneously deflating its balance sheet.  I’m not sure that this has ever been done before over any significant time period.

Of course, when the economic downturn comes, you can expect a reversal of the Fed’s monetary deflation. Not only will the deflation stop, but we are likely to see monetary inflation.  You can call it QE, accommodation, or whatever you want, but the Fed will eventually return to creating new money out of thin air.