Column: Will the Fed’s interest rate cuts have the same impact on suppressing income as they did in the 2020 era of zero interest rates?

(Oct. 2) If you think the Federal Reserve’s interest rate cuts might overstimulate the fast-growing U.S. economy, consider the opposite: their impact on futures in. It is necessary. Pictured at the Federal Reserve Headquarters in Washington, April 2012 (2024 Reuters/Joshua Roberts)

LONDON (Reuters) – If you think the U.S. Federal Reserve’s interest rate cuts might overstimulate the fast-growing U.S. economy, the opposite is true: They will stifle the future of -in you also have to think about it.

Since the Federal Reserve began significantly raising interest rates in 2022, it has increased the banking system’s interest income. It may seem counterintuitive, but lowering interest rates has the opposite effect on the income of the banking system.

Since the negative impact on the economy from an increase in borrowing costs due to interest rate increases appears to be offset by an increase in interest income, the economic effects of interest rate cuts could be partially offset by the decrease in interest income.

And if the Fed’s “Goldilocks” situation where the economy neither overheats nor slows down falls, managing monetary policy could be difficult.

Morgan Stanley recently quantified the income gains from the Fed’s rate hikes and the expected income losses from future interest rate cuts, and future models have time passed in the release of monetary policy taking into account new current developments, that had not been done.

Unlike in previous decades, the Fed now pays a lot of interest on the reserves it holds with banks. This interest rate came to a head when the Federal Reserve urgently expanded its balance sheet following the 2008 financial crisis and the 2020 coronavirus pandemic. Although excess reserves have decreased over the past year, they are still at about $3.1 trillion.

The Fed also pays interest to financial institutions using its reverse repurchase facility, which is used to manage money market liquidity. Repo balances are currently less than 20% of their peak levels, but still amount to around $300 billion to $400 billion every day and night.

In addition, approximately one-third of money market funds (MMFs) with more than $6 trillion in assets are allocated to short-term government bonds (T-bills) with maturities of one year or less. The interest rate that investors receive is largely linked to the policy interest rate. Buybacks and reinvestments have provided attractive income in recent years, but this too is set to reverse.

The number of T-bills held by investors other than MMFs is about $4 trillion.

The Fed raised interest rates by up to 5 percentage points in 2022-23, increasing interest income at all levels and reducing the impact of tight financial conditions across the economy. Therefore, using the same mechanism, it would be natural for interest rate cuts to ease the financial environment, but also to impose restrictions on market liquidity and interest income.

A team of Morgan Stanley strategists said: “A decline in interest income could dampen the impact of rate cuts, just as a rise in interest income dampened the impact of monetary tightening in 2022- 23 to raise interest rates more than it would without such an increase in interest income, it will likely have to cut rates even more sharply in the future.”

To gauge the impact of future curbs on income, Morgan Stanley estimated the negative impact on monthly income if the Federal Reserve lowered interest rates to a “neutral” level of around 3% over the next two years. The surprising result was that the scale of the loss as a percentage of gross domestic product (GDP) was almost the same as when the policy rate was cut to near zero in 2020.

These losses could include any impact on lower bank profits, corporate loans, wealth impact, etc. It is not yet clear whether that will be enough to offset lower borrowing costs from interest rate cuts.

In particular, as the US economy remains strong, the Fed is likely to absorb the impact of lower interest rates on income.

The rate hikes provided more interest income to many cash-rich companies and relatively wealthy households, providing relief to the economy. On the other hand, the revenue-suppressing effect of interest rate cuts could act as a deterrent to excessive monetary discounting.

Draw down balance sheet still draining from Fed back repos

However, serious problems could arise if an economic shock of some kind or an alarming resurgence of deflationary pressures causes the Fed to struggle to keep the US economy moving. If this happens, the Fed will have to cut interest rates much faster than currently expected.

After the coronavirus pandemic, many people felt that a world with zero interest rates was no longer a reality, but speculation has shown that prices could fall too much in Switzerland, the euro area, and even China.

If the moderate economic situation collapses, the Federal Reserve’s efforts to reduce the amount of its assets, known as quantitative tightening (QT), will no longer be easy. US commercial bank reserves are already approaching levels considered “sustainable” for the foreseeable future, and most money market analysts expect the Fed to end QT by the end of next year.

However, if the revenue-reducing effect of interest rate cuts becomes a real issue, there may be more calls for an end to QT in Fed circles.

Draw down the Fed’s balance sheet to continue even as the central bank cuts rates

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The author is a columnist for “Reuters Breakingviews.” This column is based on the personal opinion of the author.

Mike Dolan is Reuters Editor-at-Large for Finance & Markets and has worked as an editor, correspondent and columnist at Reuters for the past 26 years – specializing in global economics, policy making and financial markets across the G7 and emerging economies. Mike is currently based in London, but has also worked in Washington DC and Sarajevo and covered news events from dozens of cities around the world. Mike graduated in economics and politics from Trinity College, Dublin, previously worked with Bloomberg and Euromoney and received Reuters awards for his work during the 2007/2008 financial crisis and on frontier markets in 2010 He was a regular Reuters columnist in the International New York Times between 2010 and 2015 and currently writes twice weekly columns for Reuters on macro markets and investing.