- Some Fed officials have argued that further easing is not a deal.
- We actually think the bar is rather low, given the pressure coming from the White House.
- The Fed will likely cut rates further, and take additional easing steps.
- QT will end on December 1.
- If repo rates don’t ease, QE will follow shortly.
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Commentary: Return of QE?
The path for the Fed to keep cutting rates, a key demand of the Trump administration, is getting complicated. Fed communication turned more balanced last week after the widely expected rate cut in the October policy meeting. Not only did Chair Powell push back against the idea that another rate cut in December was a done deal, several Fed officials, voting and non-voting members of the FOMC, also stepped forward with arguments for caution. Kansas City President Jeff Schmid, who voted against the rate cut decision, was joined by Dallas Fed President Lorie Logan and her Cleveland counterpart, Beth Hammack, both of whom will be voting next year, in pointing out that the case for continued rate cut is not quite clear cut. The US labour market is largely in balance, the economy shows continued momentum, and inflation remains well above target. Substantial worsening of the labour market and significant easing of inflation is needed to justify further accommodation, along this line of argument.
We find logical alignment with the camp in favour of turning cautious, but we also see the political reality. In our view, the bar for further accommodation is rather low. The kind of pressure being exerted by the White House, combined with some large companies announcing job cuts and no sign of a jump in inflation expectations, is sufficient to keep the Fed on course toward further rate cuts. We see the December rate cut taking place with rather high likelihood.
Policy support does not have to come from rate reduction alone. As indicated recently, the Fed is done with quantitative tightening. With the central bank’s balance sheet declining to about USD6.6trln, signs of liquidity turning somewhat tight have begun to emerge, with the widely followed SOFR-FFR spread widening.
The market and the Fed have been following such developments closely. Accordingly, the Fed announced last week that it would stop its three-year effort to reduce the size of its balance sheet on December 1. Unlike the rate cut decisions, the rationale behind ending QT was widely shared among Fed officials. Given post-GFC regulations and the evolving structure of the US financial system since the Covid pandemic, a much greater amount of bank reserves seem to be warranted now to maintain market stability. There is no going back to the 2010s, lets alone the 2000s level of Fed balance sheet.
The Fed will continue unwinding its portfolio of mortgage-backed securities, but the proceeds would be reinvested into US treasury bills, which in turn would help the funding of the burgeoning fiscal deficit. The central bank did not announce any additional liquidity measures to help ease funding costs, but we don’t think that’s too far away. If the recent rise in repo rates is not reversed in the coming months, the Fed could begin buying assets to keep reserves from falling further, which would mark a return to quantitative easing.
What was once considered as emergency measures to stave off a major financial crisis has now become a routine part of liquidity management. QE is now done to keep liquidity at comfortable levels. It may also be done, in our view, in response to political pressure. The Fed’s independence is reflected not just in its rates decisions; the QT to QE transition will show its decision-making latitude as well.
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