Still Overvalued

Prior to 2008, when the Federal Reserve ran a “scarce reserve” monetary policy, just about every bank in the US had a federal funds trading desk. These trading desks lent and borrowed federal funds (reserves) amongst each other.

In other words, there was an active marketplace that set the federal funds rate. Yes, the Fed could guide the overnight rate by adding or subtracting reserves. But this system meant there was a direct link between the money supply and interest rates.

Since the financial panic of 2008, and the introduction of Quantitative Easing, the Fed has flooded the system with reserves. Reserves are so abundant that banks no longer borrow or lend them. The Fed pays banks to hold them. As you can imagine, the Fed would like to pay almost nothing to banks, as it did for nine out of the last fifteen years. Under the new system, there is no direct link between interest rates and the money supply.

Instead, the Fed just decides what rates should be. And this explains why market expectations about interest rates jump around with every piece of economic data. It’s all about what the Fed “might” or “might not” do. Earlier this year, the market was pricing in multiple rate cuts in the second half of 2023.

But after last week’s employment report, which showed continued solid job growth, the futures market finished the week with the odds of a July rate hike at almost 90%. We think the market is underestimating the odds that the Federal Reserve will raise short-term rates again this year, after July. Recent economic reports have been stronger than expected, and inflation remains stubbornly high around the world.

The Fed pays close attention to the labor market and average hourly earnings rose 0.4% in June and are up 4.4% from a year ago. We think the Fed needs to focus on actual inflation and the money supply, but its models tell Fed policymakers to focus on the labor market. Given a 2.0% inflation target and slow productivity growth, we think the Fed would like to see average hourly earnings grow at more like a 3% annual rate, not 4.4%.