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The Federal Reserve acted on Wednesday to reverse an unexpected rise of 5 basis points in its key rate since the end of March. The Fed meeting sought to indirectly reduce this benchmark by lowering the interest rate paid on banks' excess reserves to 2.35%. Rate reduction was a technical solution, not a policy change. Yet the Dow Jones and the broader stock market initially contributed modest gains. Shares have reversed downward, Fed Chairman Jerome Powell has hinted that a Fed rate cut would not be expected this year.
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The statement issued at the end of the Fed meeting also highlighted the decline in inflation, which again fell below the 2% target. At the press conference held after the meeting, Fed Chairman Powell said the Fed was "strongly committed" to its inflation target. But Mr Powell said lower underlying inflation could be partly "transitory".
Dow Jones' gains were stifled after Powell announced that policymakers are expecting fundamental inflation to return to 2% with no reduction in the Fed's rate. However, he said the Fed would be worried about persistent under-inflation.
Following the announcement of the Fed meeting and President Powell's Q & A, Dow Jones and Nasdaq Composite Indexes slid 0.6% into the stock market today. The S & P 500 index fell 0.75%. This is despite Apple (AAPL) giving a big boost to all major indices.
The 10-year Treasury yield initially dropped to 2.46% after the Fed meeting, prolonging losses after falling on a softer ISM manufacturing index. But as Powell has spoken, the decade of ten years has reached 2.52%.
Why is the cut important?
The Fed has ruled out rate hikes for 2019 and Wall Street is considering a rate cut for the end of the year. Yet, the key rate has stubbornly maintained on the rise. On Tuesday, the effective rate of federal funds reached 2.45%, its highest level since 2008.
Faced with an inflation target below the inflation target, the Fed is right to ensure that its key interest rate is not exceeded inadvertently. On the other hand, with the Nasdaq and the S & P 500 reaching a record and the nearby Dow Jones, it was not clear that policymakers feel rushed to act. This is why the technical decision taken at the Fed meeting on Wednesday initially sent a bullish signal that the Fed was more concerned about low inflation than high stock prices.
The Fed, however, seeks to find a balance between inflation and asset prices, which Wall Street might not consider optimal. Powell noted on Wednesday that he considered the financial vulnerabilities to be "moderate". He said the value of some assets seemed high, but not excessive.
Officially, the Fed raised its overnight lending rate to a range of 2.25% to 2.50% in December. Yet despite its accommodative intentions, the effective rate of federal funds has peaked. Since the Fed's key interest rate is linked to the market interest rates on credit cards and auto loans, the policy is slightly tightened.
Wall Street economists were divided over whether the central bank would try to find a technical solution at the Fed's meeting on Wednesday.
Fed's monetary policy crisis at the time of the crisis
Gradually, the monetary policy management system of the Fed in 2008 seems to be collapsing. That year, the Congress gave the central bank the power to pay interest that exceeded the requirements of the banking supervisory authorities over the reserves of the commercial banks held at the Fed.
Until last June, the Fed had maintained the interest rate on excess reserves (IOER) at the top of its fed funds rate range. But as the benchmark rate rises towards the upper end of the range, the Fed has changed course. In June, while raising its key rate by 25 basis points, it had increased the IOER ratio by 20 basis points. He did the same thing in December.
However, it is now clear that the IOER rate has not capped the key rate of federal funds. Tuesday, the IOER rose to 2.40% and the effective rate of federal funds to around 2.45%.
One of the explanations for the upward pressure exerted on the key rate by the Fed is the rise in Treasury issues and the contraction of its balance sheet by the quantitative tightening. This led to speculation that it could end QT before the end date scheduled for September.
But economists believe that the latest upward movement in the federal funds rate could have another cause: the April 15 tax deadline. Tax payments contributed to an outflow of money market funds.
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