The Federal Reserve held the effective federal funds rate constant last week at 0.33%.
Federal Reserve officials continued to talk about upcoming future increases in its key interest rate with some of the members of the Federal Open Market Committee speak of a few “half-point” increases during the year.
The Federal Reserve held its key interest rate constant at 0.08% from September 1, 2021, until it raised the policy range at its last FOMC meeting.
Since then, the Fed has held the effective federal funds rate at 0.33%.
As Federal Reserve officials increasingly talked about raising its key interest rate in March and then following up with several more hikes this year, long-term interest rates began to rise.
Take a look at what the yield of the 2-year US Treasury note has done during this period.
On September 1, 2021, when the Fed started holding the effective federal funds rate constant at 0.08%, the 2-year Treasury yield was 0.20%.
On March 17, when the Fed raised its key rate, the yield on the 2-year note was 1.94%.
On March 31, the 2-year Treasury bond closed at 2.32%.
It should be noted that this rise in the yield of the short-term Treasury bill was not accompanied by the same increases as those of the yield of the 10-year Treasury bill.
That is, the term structure of interest rates stabilized over this period, with the yield on 2-year Treasury bills rising faster than that on 10-year Treasury bills.
On September 1, the spread between the yield on the 10-year Treasury note and the yield on the 2-year Treasury note was around 110 basis points.
By March 17, 2020, the spread had fallen to around 25 basis points.
As of March 31, the spread was only about one basis point.
The US Treasury yield curve had roughly flattened.
For many analysts, this is a market signal that a recession is on the way.
But investors still expect the Federal Reserve to continue raising its key interest rate throughout 2022 and possibly into mid-2023.
But what about inflationary expectations?
Many analysts disagree with this image.
The reason for the disagreement is that these analysts do not believe that the level of longer-term yields fully reflects the underlying economic situation.
These analysts believe that the inflation expectations built into long-term interest rates are too low.
For example, currently, the inflation expectations embedded in the nominal yield of the US 5-year Treasury note are around 3.5%.
Inflation expectations embedded in the nominal yield of the 10-year US Treasury note are around 3.00%.
Yesterday it was reported that the current rate of inflation, using the Fed’s preferred measure of consumer prices, was 6.4%. Even core PCE inflation, which suppresses volatile food and energy prices, jumped to 5.4% in February,
In other words, many analysts believe that the inflation rates embedded in current market returns do not fully account for the actual inflation that the United States is going to face.
These analysts believe the Federal Reserve needs to raise its key interest rate several more times and make at least some of the half-percentage-point increases.
If so, the current mandate structure should not be flat or threatening to turn negative and we should not expect a recession any time soon.
The value of the dollar
The global situation could keep nominal interest rates as low as they are.
The value of the US dollar rose during this particular period. Two reasons are considered as the reasons for the appreciation of the dollar.
First, starting last fall, the Federal Reserve seemed to be further ahead of advanced countries in moving toward less accommodative monetary policy, which would produce relatively higher interest rates than those other countries.
Second, with the start of the Russian invasion of Ukraine, more risk-averse money began to flow into the United States, causing the value of the US dollar to rise.
Here we see the price of the US dollar against the euro. Remember that the curve descends when the dollar strengthens against the euro.
On September 1, 2021, it cost $1.1840 to buy one euro.
On March 17, 2022, it cost around $1.1000 to buy one euro, and the price has remained around that value ever since.
So the rest of the world seems to think the Federal Reserve is doing well as investors move money into the US dollar, rather than away from it.
Federal Reserve stocks
All this year, the Federal Reserve has reduced the monthly amount of securities it has purchased, purely and simply, for its balance sheet.
Prior to the start of the year, the Fed was acquiring $120.0 billion in securities per month.
Since the end of last year, since December 29, 2021 to be exact, the Fed has only added $207.5 billion of securities to its portfolio.
Since early March, since March 2, 2022 to be exact, the Fed has only acquired $34.8 billion in securities. This latest figure includes two weeks in which the amount of securities on the Fed’s balance sheet actually declined. In the last banking week, the one that ended March 30, 2022, the Fed saw its holdings of securities actually shrink by $22.7 billion.
Since the end of the year, the Fed has seen reserve balances with Federal Reserve banks, an indicator of excess reserves in the banking system, shrink by $266.4 billion.
It is assumed that this drop was necessary to prepare the banking system for the increase in the Fed’s key interest rate.
Now, it will be interesting to see what the Fed is doing to manage its securities portfolio and continue to raise its key interest rate.
This is supposed to be the policy intent of the Fed, going forward. The interesting thing for investors will be to see the strategy used by the Fed to keep the key interest rate on the rise. How the Fed will achieve this is the big question for investors.