From a money manager who not ONLY owns an MLB team but who could ALSO bench press a VW Bug, comes the following thought
Forget Raising Rates, Shrink the Balance Sheet
The Fed’s best opportunity to “normalize” policy.
…Clearly the markets have become a speculator's paradise. Meme stocks, CCC bonds, art, houses, almost anything that can be named has skyrocketed. And if there were not enough opportunities for speculation, new avenues like non-fungible tokens and virtual real estate are available for those who have the courage to invest.
… Policymakers have now determined that the answer is to begin a rapid reversal of the stimulus that it continues to supply. This includes a rapid reduction in asset purchases, which will probably sunset in March, along with an almost immediate liftoff in the fed funds rate. Some market participants are calling for hike of 50 basis points as early as March and many economists are pushing for 100 basis points before year end, while numerous Fed officials are pushing for balance sheet reduction as soon as possible.
What amazes me is that the Fed would even consider an attempt to raise rates and reduce the balance sheet simultaneously given how badly the last episode of balance sheet reduction played out in the markets while the Fed raised rates in 2018. That effort abruptly ended with the famous "Powell Pivot" after the stock market fell sharply when Fed Chair Jerome Powell announced that balance sheet reduction was on autopilot.
Changes in money supply are a powerful driver of economic output, asset prices, and inflation. Interest rates are the byproduct of monetary liquidity, economic output, and inflation expectations. Short-term market rates can be manipulated through changes in the stock of money. Today, that stock of money is so large that the Fed had to ramp up reverse repo (RRP) operations to sop up cash that would have driven short-term rates below zero. That facility now has daily volume of over $1.5 trillion. Any program to raise rates will require the Fed to raise the rate of interest paid on RRP operations by the amount of the increase in the overnight target rate.
In essence, the Fed will establish an artificial rate which is not set by market forces. Without market forces, the Fed will have no ability to recognize what the true demand for money would be if interest rates could freely float and thereby create a signaling mechanism to indicate the true equilibrium rate of interest. (This is an argument I presented at The Hoover Institution's 2019 Monetary Policy Conference.)
A freely floating short-term rate would signal when policy had become too restrictive if inflation falls below target (which means that the Fed needs to increase the size of its balance sheet) or that policy has become too accommodative if inflation is increasing above target (in which case the Fed needs to reduce the size of its balance sheet).
By abandoning the policy of set ranges for pegging short-term rates, the Fed could allow market forces to determine the appropriate overnight rate while monitoring inflation and adjusting the balance sheet to determine the appropriate level of money supply—just as Paul Volcker did to successfully vanquish inflation in the early 1980s.
Market pundits advocating a “shock and awe” policy of a 50 basis point increase in rates, or former Fed officials speculating that a 4 percent overnight rate could be necessary to contain inflation, reflects a degree of hubris which could do even more harm to the financial markets and the economy.
Who knows what the "right" level of interest rates should be? Can you imagine what would happen to the housing market if rates rose to 4 percent or higher, or to equities in the event of a sudden, unexpected rise in interest rates associated with "shock and awe”? Perhaps that's a great idea if you are short stocks. The market is already waffling with the talk of three or even four quarter-point rate hikes along with balance sheet reduction even before the Fed has taken action along these lines. An unexpected shock is not going to immediately flow through to inflation, but it will immediately impact already overvalued financial asset prices and undermine confidence and destabilize the economy.
The simple fact is that no individual or committee is smarter than the market. As the Fed’s balance sheet shrinks, the excess liquidity stored in its standing repo facility will slowly decline. As the cash balances at the reverse repo facility dissipate, short-term rates will begin to move higher. This will allow financial markets to find a new equilibrium as the Fed reduces its balance sheet as inflation declines.
… Does any of this sound familiar? Perhaps we should heed the wisdom of Mark Twain, who said, "History doesn’t repeat itself, but it often rhymes," and go with a proven solution by controlling money supply growth through the Fed’s balance sheet rather than repeating the mistakes of the 1970s.
SOURCE: https://www.guggenheiminvestments.com/GuggenheimInvestments/media/PDF/CIO-Outlook-Forget-Raising-Rates-Shrink-the-Balance-Sheet.pdf