Banks reported steady core net interest income (NII) and net interest margins (NIM) in Q4 2024 as most of the negative earnings effect of deposit migration over the past two years from noninterest-bearing deposits to interest-bearing deposits ran its course. In addition, the Fed’s rate cuts last fall helped ease some of the deposit repricing pressures they absorbed that were putting upward pressure on their funding costs, and they benefited from favorable deposit repricing beta in their commercial deposit accounts. Nevertheless, the broad balance sheet trends in Fed H.8 data suggest that the industry’s modest loan and deposit growth will continue, which banks need to improve to expand operating leverage in 2025. Bank treasurers are counting on legacy fixed-income assets continuing in 2025 to pay down and that they will be able to reinvest proceeds in higher-yielding bonds and loans to help put upward pressure on their NIMs and NIIs. They also do not anticipate shifting more cash from their Federal Reserve deposit accounts into bonds, although if the yield curve became steeper, it might change their plans.

Last fall, the Fed’s rate cuts caused Treasury yields across the term structure to bear steepen into a normal, positive-sloped curve, which bank treasurers at institutions of all sizes agree helps them maintain earnings momentum this year. Before the Fed’s first cut last September, the spread from 3-month to 5-year term was -160 basis points, and the spread from 3-month to 10-year term was -145 basis points. Following the Fed’s third rate cut this month, those negative spreads turned to positive spreads, with the 3-month-5-year spread and the 3-month-10-year spread increasing to +14 and +34 basis points, respectively. After the Fed finishes easing, the yield curve spread averages 200-300 basis points.

Although the yield curve returned to its normal positive-sloped shape, this was the first time that it bears steepened through an easing cycle over the last 40 years, which generally rallies rates across the term structure and causes the curve to bull to steepen, with shorter-term yields falling by more than longer-term yields. The curve’s bear-steepening this time, where the 3-month rate fell by 100 basis points. At the same time, the 10-year increase by the same amount suggests that the Fed’s struggle to accurately project the economy or the direction of its interest rate decisions is damaging its credibility with market participants, who have grown more skeptical that the Fed will cut interest rates in 2025 and do not rule out even a rate hike if inflation remains elevated or potentially increases again should U.S. tariff policy impact the public’s inflation expectations. Bank treasurers are still budgeting for one or two rate cuts in 2025 but generally agree that a cut this month or even in March is unlikely. Officials do still encourage market participants to expect interest rates to move lower to a neutral level but concede that they are less and less sure how much lower neutral is from where they have rates now, adding to skepticism by bank treasurers that the Fed has a handle on the economy or interest rates.

Quantitative tightening (QT) in this rate cycle also runs differently than when the Fed shrank its balance sheet from 2017 to 2019. In QT 1, the Fed stopped shrinking its System Open Market Account (SOMA) holdings of Treasury and Agency Mortgage-backed securities (MBS) when it began cutting rates in July 2019, but this time, it cut rates last fall and shrank its balance sheet at the same time. Bank treasurers may care about the Fed’s balance sheet size and its clout in the Treasury markets, believing it should not be as large as it is. They also expect that QT should put upward pressure on Treasury yields. However, even though the Fed owns almost twice as many Treasury securities today as it did in July 2019, the treasury debt outstanding increased from $28 trillion to $36 trillion. With only $25 billion running off the Fed’s balance sheet under the monthly cap that has been going back into the Treasury market, and with the prospect of new Treasury supply post a debt ceiling agreement, the Fed’s ability to influence markets with QT is shrinking month by month along with the size of its balance sheet.

Elsewhere on the Fed’s balance sheet, the banking industry all but fully repaid loans drawn under the Fed’s Bank Term Funding Program (BTFP), which one year ago stood at $167 billion and today equals $3 billion. Sitting on the left side of its balance sheet along with its SOMA account, when the balance of the BTFP declined last year, it also reduced reserve deposits. But the Fed replenished those reserve deposits by running down its Reverse Repo Facility (RRP) balance, which, like reserve deposits and the Treasury General Account (TGA), sits on the right side of its balance sheet. The balance of the RRP is now down to $100 billion from over $2 trillion last year, which means that reserve deposits, equal to $3.3 trillion, may finally begin to edge lower, assuming the Fed continues with QT this year. But for now, as the Treasury operates under extraordinary measures until Congress passes the debt ceiling, the $550 billion sitting in TGA will run down, holding back QT’s downward pressure on reserve deposits from the run-off in SOMA.

The Bank Treasury Newsletter-January 2025

Dear Bank Treasury Subscribers,

Yeah, happy New Year. Whatever. The whole New Year business is a load of whatever, too. Do you know what Monday, January 6, was this month? It was “You got your long weekend, now get back to work day,” that is what it was! And besides, it is after Martin Luther King Day, so you are not even supposed to wish people a new year anymore.

Yeah, get back to work because—news flash--brace yourselves. Everything that bothered you about your job last year will still bother you this year. Only it will probably be worse, given how things have turned out. And it is all the Fed’s fault because it cannot do its job right.

Seriously. It is terrible. The Fed cannot do monetary policy, it cannot seem to supervise banks very well, and if it stinks at anything more than those two essential functions, it is transparency and communication. For all the data dependence it is always talking about, its decision-making remains a black hole. Maybe its dot plot projections used to mean something, but today, they are not worth the paper to print out and save.

It is terrible at its job. You disagree? The big banks are even suing it because they say it is not transparent around stress testing. How much worse can you be as a critical cog in the financial system than if the industry you regulate sues you? Bank supervision is not supposed to be adversarial, as Fed governor Michelle Bowman said this month.

The Fed has mucked itself up. It may be earning a gold star with its effort on payments because the statistics coming out of FedNow these days are impressive. But otherwise, what the Fed has been doing very well is convincing every capital market participant that it does not have any better idea of what is around the corner than they do, which is just not good. Because its job is to know more than every other market participant, it is the Fed, all-knowing puppet master of the rates markets. Or it was. When it raises rates on the front end, rates across the term structure rise; when it cuts, all rates fall. But not today.

And the newsletter is a free publication that points fingers where fingers are due. The Fed’s economists do not generally admit things like, “You know what? Gee whiz. We do not have a clue. We do not know what we are doing.” But here, our editorial staff will not be restrained out of professional courtesy as no one working here is a degreed economist, so who cares? We can take potshots all day and will because the Fed economists deserve it.

Everything that has gone wrong in the markets is because the Fed has failed at its job. Does anyone remember when it raised rates from 2004 to 2006 and triggered the Global Financial Crisis? Or place in September 2019 when it let the level of reserve deposits fall too low, which caused a crisis in the repo market? Or delaying the rate hikes it belatedly got to in March 2022 and supposedly exacerbated inflation problems? That was the Fed failing at its job.

It is all the Fed’s fault. The 10-year Treasury yield is up 100 basis points since the Fed’s first surprise hike last September because the market concluded that the Fed’s rate cuts and threats of tariffs will push up inflation and even raise the risk that the Fed will reverse course and hike again. The weak loan growth? Loans were supposed to be picking up by now, but with rate cuts on hold and the higher 10-year loan growth, it does not look like it will happen anytime soon. Thank you, Federal Reserve.

Bank treasurers. If you want somebody to blame for the backup in the yield on the 10-year that pushed the rate on a 30-year mortgage back up to 7%, thus sending the home mortgage purchase index into the toilet and killing your hopes to see your bank originate more mortgage loans this year, look no further than the Fed and its monetary policy. As the CFO at one of the largest banks admitted to bank analysts this month, discussing Q4 2024 results and looking out to this year,

“Mortgages will likely continue to decline given the rate environment we're in. We did see a little bit of incremental refinance activity in the fourth quarter. But now with rates back up, that seems to be back down again.”

The Fed’s pause kills everything now, especially the momentum bank treasurers were hoping to see on loan growth, as the CFO of a regional bank in the southeast explained,

“The high rates have been having an effect on pipelines, delaying start up projects.”

How can it be that the Fed cuts Fed funds by 100 basis points and loan growth remains weak? Rate cuts are supposed to act like a starting gun. However, this outcome was because the Fed bungled the rate cuts. Rate cuts were supposed to be good, but they gave you more headaches.

Pile on and blame the Fed. The insane negative AOCI that is still impairing bank balance sheet liquidity is the Fed’s fault. Don’t blame bank treasurers for reaching for yield by extending in 2020 and 2021 in those dark days when loose talk of Negative Interest Rate Policy and theories by Fed officials about their tolerance for above-target inflation encouraged them to believe that it would be a long winter of lower for longer, and that buying 2% and 3% MBS would protect their bank’s NIMs and NIIs. Negative AOCI is on the Fed because dirt is worth more than the value of their public communications.

And if you happen to be one of those bank treasurers who sat in cash back then and resisted the siren song of 2% and 3% MBS, which back then was 100 basis points above your cost of funding, if you were the face of disciplined investment management and now you walk on water when you meet with your board to discuss investment options (and many read this newsletter in those ranks), just remember this. Had the Fed been competent at its job, the inflation genie might have never escaped, and the Fed might have never needed to go so high and fast on rate hikes that gave many of your peers a bad case of negative Accumulated Other Comprehensive Income (AOCI).

Fed funds might have never gotten higher than 2.5%, the long-term Fed projection. How smart would you look today if that had happened and the cumulative returns on your cash pile since 2020 and 2021 had, at best, matched but probably never exceeded the interest income you could have earned all that time in 2% and 3% MBS? That could have happened if the Fed knew what it was doing.

And everything it does makes things worse. Thanks to its rate cuts, the interest income on the cash pile you still leave at the Fed is down 100 basis points. In these crazy times, it is not as if you have a choice in leaving cash there. It is not as if you want to lock up ready cash in less liquid bonds when you might need it at any moment. You just must grin and earn less. And, thanks to the sell-off in the 10-year Treasury while the Fed was cutting rates last fall, if you did buy any MBS last September for your AFS portfolio thinking that it was a good time to extend when the Fed starts cutting rates, you might have a little negative AOCI to keep you up at night.

You are doing an unbelievably terrible job, FOMC voters. Keep up the good work!

It is probably done with rate cuts in this cycle, but officially the Fed still projects some, and bank treasurers still have a couple in their budget this year. The CFO of a large bank in the southeast told analysts,

“We've got the two cuts in now in March and September.”

The CFO of a large bank in the Midwest said the same thing,

“We expect two cuts.”

But maybe that first cut does not materialize until late in the year, according to the CFO of a regional bank in the southeast,

“There's a likelihood that we don't see a first rate cut until September.”

Even the odds of a September cut are low. Most bank treasurers have already dialed back their rate-cut projections for 2025. The CEO, president, and chairman of one of the global banks reminded analysts that the chances of even one rate cut this year are way down since last fall,

“In October…the amount of rate cuts was still three or four more than we've had so far. Now we're down to one.”

Who knows? There might even be a rate hike this year, according to a CFO from a regional bank in the southeast,

“There could be one to three cuts. But I even saw a Wall Street Journal article that was talking about increases.”

But most likely, the Fed is done because for decades of rate cycles, a pause has usually meant done. And Governor Bowman could not have made that point clearer when, speaking before the California Bankers Association this month, she said,

“The target range now reflects 100 basis points of cuts since September, and the policy rate is now closer to my estimate of its neutral level, which is higher than before the pandemic. But given the lack of continued progress on lowering inflation and the ongoing strength in economic activity and in the labor market, I could have supported taking no action at the December meeting.”

Then again, never say never is a theme in the post-apocalyptic Covid times we live in today, where uncertainty reigns and where budget projections for NIMs and NIIs are as unreliable as the Fed’s dot plot projections. As the president and CEO of a community bank in the southwest told analysts this month,

“The current rate of inflation and other economic factors have caused the Fed to possibly pause their interest rate reductions, therefore, we continue to acknowledge a bit of uncertainty relative to interest rates.”

Make the Yield Curve Normal Again

Do you know what the Fed is supposed to be good at when it cuts interest rates? Making the yield curve normal again. You go in with a flat or inverted yield curve, and you come out with a normal, positive-sloping yield curve. Do you know what bank treasurers can do with normal yield curves? Make NIM and NII. They can roll down the yield curve to maturity and accrete to par value. Bank treasury 101! Normal is good, at least as far as bank treasurers are concerned.

However, it is also a good time for asset managers because a normal yield curve forces investors to move money into longer-term investments. As the chairman and CEO of a large asset manager told analysts,

“We've been living in a world of an inverted yield curve. And you had the ability to earn the highest return on keeping your money in cash. But as you noticed, the yield curve is steepening. And so, you're going to, over the time, you're going to benefit by going out the curve. That said, there's close to $10 trillion of money in money market funds as that money will be put to work. The steepening of the yield curve, and higher rates are going to lead to some great opportunities in the fixed income area.”

And for bank treasurers who pay attention to fixed income technical data, the term premium on a 10-year 0-coupon bond this month is 0.8%, a level it has not exceeded since 2010. That is not an inadequate premium for bondholders to earn for extending the term to maturity. As the CFO at the same asset manager observed,

“The term structure of interest rates…has been negative for years, and now the US term premium has reached its highest level in a decade.”

Normal is all that bank treasurers want, the steeper the better. As the CFO from a large bank in the Midwest explained, his bank’s NIMs and NIIs depend on it.

“A steeper curve, the better off we are, if it's more inverted, then that would put a little bit more pressure on the net interest income.”

In fact, forget more rate cuts. Those matter less than the shape of the yield curve as far as bank treasurers are concerned. As the CFO of a regional bank in the southeast said, to realize the bank’s NIM and NII projections, he needs a steep curve,

“I would say less rate cuts, a steep curve, and more certainty in the economy going forward should help us to be at the higher end of the range.”

Just in terms of the before and after shapes of the yield curve, the Fed did not do such a lousy job with its rate cuts, forgetting the damage done to AOCI from the 10-year Treasury sell-off and that bank treasurers are out 100 basis points on the cash piles they hold at the Fed. If you want to start with a clean slate for the new year, you can probably work with this yield curve. As the CFO of a large regional bank in the southeast told analysts,

“Today's curve is, I think, attractive and to the extent that we can hang on to a long end that does benefit the fixed loan and the securities repricing. That's something we have our eyes on.”

A steep yield curve, if nothing else, would encourage bank treasurers to look at more strategies to reposition their bond portfolios and eliminate some of their low-yielding coupons to buy higher-yielding ones. But it would need to be steeper than the one prevailing today, with no more than 15-20 basis points separating the rate on a 3-month Treasury Bill and a 10-year Treasury. As the CFO from a large regional bank in the southeast said about his plans to do more bond portfolio restructuring this year,

“We've been trying to take losses with a payback period under three years…If we have a steeper curve, maybe that makes some sense to us.”

Make the Yield Curve Normal the Normal Way

However, how you get to a positively sloped yield curve also matters, which is why Figure 1 perfectly illustrates how much the Fed mucked up its rate cuts last fall. The graph compares the before and after Treasury yield curves from overnight to 10 years, which existed just before the Fed’s first cut last September, to the yield curve prevailing this month after the rate cuts.

**Figure 1: Rate Cuts Sent the Front end Down, and the Back end Up**

Notice how the two yield curves intersect around the 2-year Treasury? That is not supposed to happen. X does not usually mark the spot with before and after yield curves. The entire yield curve moves lower when the Fed cuts the overnight rate. Rate cuts have a holistic effect on all interest rates, but the yield on the front end is supposed to fall further than the back end. Yield curves are not supposed to bear steepen when the Fed cuts, with the back end going up while the front end goes down. That is not normal. Yield curves are supposed to bull and not bear-steepen.

Rate-Cutting Cycles in the Past

Last September, when the markets were putting all sorts of pressures on the Fed to start cutting rates, bank treasurers assumed the yield curve would bull steepen into a normal curve, given previous rate-cutting/easing cycles. Over the last 40 years, the Fed went through five other rate-cutting cycles aside from the one last fall. It eased in 1984-86, 1989-91, 2001-02, 2007-09, and 2019-20. Every time, the yield curve bull steepened.

In July 2019, the economic expansion began after the GFC reached a historic milestone, the longest continuous expansion in U.S. history. Yet the longer it continued, the more obsessed bank treasurers with the belief that all things, even economic expansions, end. As speculation intensified that a recession would strike by the end of 2019 or by 2020, the yield curve began to invert, and bank treasurers needed to explain to board members why, even if an inverted yield curve is usually a harbinger of recession, this time was different.

The U.S. economic expansion started in Q1 2019 at 3.2% but fell to 2% in Q2 2019, and the IMF warned that the world economy was slowing down. Tariff disputes may have also had a hand in economic performance. To protect the economy, the Fed began easing.

The FOMC voted to cut 25 basis points from the range at the end of July 2019 to 2.00%-2.25% and to end quantitative tightening (QT). The move was well-telegraphed; the forwards already had the cut in its numbers, and the cut seemed to quell market qualms about recession risk. But on September 15, just before the next scheduled FOMC meeting on September 18, the repo market blew up. For whatever reason, because of the coincidence of expected tax payments and securities settlements in the Treasury market, reserve deposits were suddenly insufficient to meet demand on FedWire, and SOFR jumped by 300 basis points.

The Fed was derelict in monitoring FedWire volumes and anticipating the risk of a shortfall in reserve deposits that day, but not dwelling for long on its mistake, it moved quickly to stabilize financial markets and cut Fed funds by 25 basis points at its September meeting and then again at its October meeting. It also purchased a slug of Treasury Bills to top up reserve deposits that QT had reduced by $1 trillion to $1.4 trillion.

Then Covid struck in March 2020, which led the Fed to reduce the overnight rate to the 0-lower bound. When the dust settled, bank treasurers were not only able to work in their pajamas and sleep in a little bit in the morning, but they also had a normal sloping yield curve and nearly 100 basis points of spread between the overnight and the 10-year to work with to generate NIM and NII (Figure 2).

**Figure 2: The Fed Tries to Stimulate the Economy and Respond to Covid**

Normal Curves Are Supposed to Stimulate the Economy

Rate cuts are the Fed’s way of stimulating the economy. That is what the Fed wanted to do during the GFC. Bank treasurers had a marginally inverted yield curve when the Fed cut 50 basis points at its September 2007 meeting. It had been inverted for over a year since the Fed’s last rate hike in June 2006. But the wheels continued coming off the financial system after the cut in September, as troubles in the housing market alarmed the Fed about a growing abyss that was forming under the banking system. So, it kept cutting, and by the time the Fed finished cutting rates to 0% at the end of 2008, bank treasurers could have feasted on a juicy 250-basis point spread from overnight to 10-years (Figure 3).

**Figure 3: The Fed Responds to the Global Financial Crisis**

The yield curve bull steepened before then, too, when the Fed eased after Y2K when markets were troubled by the dot.com boom and still reeled after 911. Its first-rate cut by 50 basis points was an emergency cut, announced in a press conference on January 3, 2001, the first business day of the New Year before its regularly scheduled meeting of the FOMC at the end of the month when it cut Fed funds by another 50 basis points, bring the rate down to 5.5%. And it kept cutting until the range on the Fed funds rate by the end of 2002 was 1.00-1.25%.

When it finished, an inverted yield curve turned into a bank treasurer’s dream yield curve, with a 400-basis point spread between the overnight rate and 10 years (Figure 4). In 2003 and up until the Fed began to hike rates in June 2004, bank treasurers were minting NII, buying intermediate-term spread products with 7% coupons all day long, rolling those coupons down the yield curve, and accreting NIMs to the tune of 4%, a level of NIM performance that no bank treasurer has seen ever since. Those were the days.

**Figure 4: The Fed Responds to the** **Dot.Com** **Boom, Y2K and 9-11**

There were two other easing periods over the past 40 years, one between 1984 and 1986 and another between 1989 and 1992. The Fed managed monetary policy differently back then, targeting money supply, for example, instead of the Fed funds rate as it is now. Public communications also were not as explicit as they are today. The Fed did not say back then that it was raising rates or cutting and by how much. It spoke about managing money supply growth within a range through open market actions to control reserve deposits, which were required back then. Thus, the before and after graphs in Figures 5 and 6 cover periods when the Fed’s discount rate fell continuously by several hundred basis points over a concentrated period.

Bank treasurers remember that the 1980s was a decade of financial crises, from a savings and loan crisis to a commercial real estate crisis to a crisis with loans to so-called Lesser Developed Countries. Prominent banking names such as Bank of New England failed or had so many asset quality problems that they were forced out of business, such as Manufacturers Hanover and Continental Illinois, into the acquiring arms of their competitors. In October 1984, worried that the economy was slowing and as a preventative measure against recession, the Fed began easing, cutting the discount rate from 9% when it started down to 5.5% by September 1986 when it finished.

Paul Volcker led the Fed in October 1984 when the cutting cycle began, but by the time the Fed paused in September 1986, it was under Alan Greenspan’s leadership. More importantly, the rate cuts caused the entire yield curve to bull flatten into a positively sloped curve that gave bank treasurers over 150 basis points of spread between the overnight and 10-year rate (Figure 5) with which to work to make NIM and NII. On the other hand, the rate cuts did rally the 10-year yield, which fell from 11.6% before Paul Volcker began easing to 7.5% when Alan Greenspan stopped.

**Figure 5: Fed Tries to Stimulate Economic Growth in The Mid-80s**

The late 1980s were a tricky time for the Fed, not just because it had a commercial real estate crisis on its hands that was raging on a national level but also because it threatened the solvency of many of the nation’s largest banks. It had also just committed the U.S. banking system to adopt Basel 1, a capital standard that the U.S. and other major central banks had adopted in 1988, which, when fully phased in by the end of 1992, would raise capital requirements.

No Fed official would ever have admitted this. Alan Greenspan liked to talk about maintaining a “constructive ambiguity” with his monetary policy decisions. Still, when the Fed lowered the discount rate from 10% in May 1989 to under 3% by December 1992, it not only shifted the entire yield curve lower and turned a before yield curve in May 1989, which was marginally inverted to one with a 3-point positive slope by December 1992 (Figure 6), it generated NII and NIM for banks struggling to fund their credit provisions for loan losses and meet their new higher capital requirements.

**Figure 6: The Fed Responds to The Late-80s Early 90s Bank Crisis**

Dark Stars

Monetary policy under Paul Volcker and for most of the 1990s under Alan Greenspan was based on managing money supply growth to control the economy and indirectly influence interest rates. When it saw money growing above target, the Fed made scarce reserve deposits even scarcer, which slowed money supply growth. When it saw money growing below target, it increased the supply of reserve deposits which increased money supply growth. Faster or slower money supply growth, in turn, sped up or slowed down the economy. It also led interest rates higher or lower. There was nothing about data dependence and changing interest rates accordingly back then in the statements. At least not directly.

You never knew when the Fed was hiking or cutting rates because it controlled rates indirectly. Yes, members of the FOMC reviewed the country's economic performance like they do today, but changing money supply growth does not have the same immediate impact on interest rates the way the Fed can change rates today. It took time for the Fed to change rates back then, which was by design.

Paul Volcker was an acolyte of Milton Friedman, an economist who preached against targeting interest rates to respond to inflation price data because the data was unreliable and because even if it were reliable enough, he believed that the role of central bankers should be to keep an even keel on the economy and not try to change course so quickly because a lot of economic data is just noise. He also did not think economists could use it to make accurate enough projections to avoid over or under-tightening or changing policy too early or too late. Milton Friedman did not believe in data dependence, especially backward-looking data.

In 1997, money supply targeting was not working the way it used to work as a monetary policy tool when Paul Volcker used it to break the inflation fever that gripped the country when he became Fed chair in 1979. Alan Greenspan formally abandoned money supply as a target for monetary policy and consigned his copy of Milton Friedman and Anna Swartz's seminal work, "A History of Money," to one of the top dusty shelves in his bookcase with some of his other dusty economic texts. From then on, the Fed's conduct of monetary policy became what Milton Friedman had warned against as it came under the influence of an economic dark star.

Without a money supply to focus its attention, the Fed turned to the stars, charting a course guided by a polestar known as R-Star. R-Star is a theoretical, risk-free, inflation-neutral interest rate that lies at the heart of every economic model that economists have ever used. It is an ideal rate for a perfect economy at full employment, where the supply and demand for money are balanced. R-Star defines whether monetary policy is restrictive or expansive. When the Fed raises rates above R-Star, its monetary policy is restrictive, and when it lowers them below R-Star, its policy is expansive.

As a neutral, inflation-adjusted, overnight, risk-free interest rate that brings the economy into perfect balance, one would think R-Star would be stationary. Whether the economy grows faster or slower, whether nominal interest rates go higher or lower, no matter how the economy evolves, something like R-Star, billed as an ideal interest rate, has no business wandering around. John Taylor, an economist at the Fed in the 1990s, came up with the famous Taylor rule that said the Fed should be raising interest rates when the inflation rate is higher than the target rate and probably would not have approved of any of the Fed's recent rate cuts, assumed that R-Star was 2.0%. But in fact, Fed economists are not and may never have been sure if R-Star does, in fact, equal 2% or is even a constant in the sky like Polaris, the north star ancient mariners used to steer their ships in the night.

R-star could be a wandering star, otherwise known as a planet in astronomical terms. As any seasoned mariner would tell you, you do not use planets to steer a ship, and they probably do not make much sense to use to steer an economy, either. R-Star should be a constant, up there, with other constant constants, such as the Hubble constant, that astronomers believe dictates the universe's expansion. Fed economists have known about R-Star's proclivity to wander for a long time. As Milton Friedman once said in 1968,

“Unfortunately, we have…no method to estimate accurately and readily the natural rate of either interest or unemployment. And the ‘natural’ rate will itself change from time to time.”

Which does not make for a very good way to manage monetary policy for the world’s largest economy. As Chair Powell admitted back in 2018 at Jackson Hole,

"Navigating by the stars can sound straightforward…Guiding policy by the stars in practice, however, has been quite challenging of late because our best assessments of the location of the stars have been changing significantly."

Whether or not R-Star ever led the Fed in the right direction, the challenges with its estimation might help explain why, since the GFC, the Fed's conduct of monetary policy has consistently underperformed expectations and Fed objectives. Thus, it held Fed funds at the 0-lower bound for seven years after the GFC, which should have turbo-charged the economy if R-Star was at 2%. Instead, GDP barely eked out 2%, and inflation frequently trended below its 2% target. Its misestimation of R-Star might also explain why the Fed, still claiming inflation was transitory in 2021, ended up late to hike rates and why, having hiked rates to the highest they have been and at a faster pace than it did in decades, the economy still shows no signs of slowing down.

R-Star's potential to be misestimated by the Fed, which is a given since the Fed uses several models to estimate it which come out with different answers, also raises difficult questions about whether the Fed has any credibility left that it has a handle on monetary policy and the economy. Because if the Fed does not know the location of R-star, how can it judge whether the effective Fed funds rate which it is holding today at a range of 4.25% to 4.50% is stimulative or restrictive, or whether the 100 basis points it lopped off the rate did anything at all to affect economic conditions? How can it take credit for bringing inflation down, if it cannot say that its restrictive policy has been restrictive enough or that it had any hand in bringing the U.S. economy in for a soft landing.

Perhaps the R-star is irrelevant because no one can see it, and the rate economists believe to be neutral might not have any causative connection with the economy. Because maybe there is no ideal perfect interest rate around which the price of money changes hands. Indeed, borrowers and lenders who may not be central banks but constitute a significant element of a thriving economy do not base their economic decisions on it. The rate is the rate, take it or leave it and they do not let it bother them if they are borrowing or lending at a rate that was better or worse than R-Star.

The Covid Effect on Monetary Policy

In the wake of the GFC, in addition to the Zero Interest Rate Policy it adopted, the Fed initiated an ample reserve policy, which meant that instead of keeping reserve deposits scarce relative to required reserves, the Fed maintained reserves well beyond demand for reserves. Banks primarily need reserves for liquidity purposes, to use as collateral, and to make payments over FedWire. The Fed’s ample reserve policy should have satisfied these objectives because the Fed increased the level of reserves from $10 billion before the GFC to $2.5 trillion five years later and then to $3.4 trillion after Covid, which it has held ever since.

Other than following something they cannot see, its ample reserve policy might also help explain why its monetary policy is not working right. With abundant reserves and no reserve requirement for banks, the Fed directly controls the price of overnight money with the rates it pays for reserves and its Reverse Repo Facility (RRP). Without these rates, the interest rate for overnight money under the fundamental laws of the universe called supply and demand would fall to 0%, as by definition, “ample” means the Fed is committed to maintaining more supply of reserves than demand. These artificial rates it uses to change interest rates may not work the same way in the economy as before its ample reserve policy went into effect after the GFC.

Covid changed the dynamics driving the workforce, and the flood of fiscal stimulus compounded the effect of the Fed’s ample reserve policy, making interest rates less of a factor in economic decision-making. It also made the data that the Fed uses to decide on monetary policy more unreliable. As Fed Governor Bowman observed when she spoke earlier this month,

“The labor market data have become increasingly difficult to interpret, as surveys and other measurements struggle to incorporate large numbers of new workers and to accurately account for other influences. As the dynamics of immigration and business creation and closures continue to change, it has become increasingly difficult to interpret the monthly data from the payroll and household surveys. It is crucial that U.S. official data accurately capture structural changes in labor markets in real time, such as those in recent years, so we can more confidently rely on these data for monetary and economic policymaking. In the meantime, given conflicting economic signals, measurement challenges, and significant data revisions, I remain cautious about taking signal from only a limited set of real-time data releases.”

QT: Shrinking to Irrelevance

Beyond its monetary policy wanderings with R-Star, the Fed fails to communicate its policy well because its message is confusing. QT is a perfect example of this problem, which the Fed has continued since it began cutting the Fed funds rate last September. If QT is supposed to be a tool the Fed uses to tighten policy and cutting rates is a tool to ease policy, what does the Fed mean when it uses both tools in combination?

QT is supposed to reduce the supply of reserve deposits as Treasury and Agency MBS securities mature from its SOMA portfolio and the Fed does not replace them, leaving the Treasury’s refinancing to banks and the rest of the public to buy instead. This is supposed to reduce bank deposits as investors draw down on their accounts to pay for their investments, forcing banks to reduce their reserve deposits at the Fed. But what message is the Fed sending when it cut rates by 100 bases, continued with QT, and after 2.5 years, the balance of reserve deposits in the system is unchanged?

QT’s relevance to the Treasury market is declining, just looking at it on paper. In 2015, the Fed owned $2.5 trillion in Treasurys in its SOMA account, while total Treasurys outstanding equaled just under $10 trillion. Today, its Treasury holdings equal $4.3 trillion, and total Treasury outstanding equal $36.6 trillion. With every passing month, its holdings shrink by $25 billion. At the same time, Treasury debt has increased as it has been and will likely continue to grow. The Fed’s ability to use its balance sheet to help stabilize Treasury markets in times of stress is shrinking along with its balance sheet.

What is the message it wants to communicate by continuing with QT? Is there even a message? Given how much its monetary policy has underperformed its stated objectives, and it is questionable whether it is even still as relevant as it once was to control interest rates, inflation, and the economy, it might be fair to wonder if anybody at the Fed knows, either.

Dancing Fed Dots

When the Fed began publishing the dot plot in 2012, its intent was to make the Fed’s monetary policy more transparent to the public. The public should know how FOMC meetings are deliberative and encompass a range of estimates. But what can be less transparent than sending out so-called projections that never turn out right? Milton Friedman must be shuddering in his grave over the Fed’s dancing dots.

Last September, most of the dots, which stand for the voting and nonvoting members of the FOMC, projected that the Fed funds rate would fall to 3.5% by 2025 and stabilize at 3.5%. But last month, the dots were revised entirely, projecting that Fed funds would end up at 4.0% this year? Shouldn’t Fed officials, with their hands on all the data, be able to manage a projection that it stands behind for longer than three months? Of course, data dependence means the dots can dance, but in September 2024, the unemployment rate was 4.1%, and CPI was 2.4%. In December 2024, the unemployment rate was 4.1%, and CPI was 2.6%. How much data changed, especially given that both inflation readings were in their projected range of outcomes?

Consistency matters and projections need to be accurate. You cannot just put out completely off projections and keep changing them with every update. What is the value of doing that for bank treasurers who pay attention to this stuff? Most of the dots in the December 2021 dot plot, when the Fed funds rate was still at 0%-0.25%, projected that the Fed funds rate would increase to 1% by the end of 2022 and get no higher than 2.5% by 2023. By March 2022, the dots jumped by more than 100 basis points, with Fed funds projected to reach 2% by the end of 2022 and get over 3% long-term. Each successive dot plot the Fed published that year projected higher and higher long-term Fed funds. Its year-end dot plot projected that Fed funds would get close to 6% in 2023 and stay at that level at least through 2024. Bank treasurers know how that projection turned out like all the rest of the Fed’s projections.

Make the Fed Credible Again

The Fed may not have a crystal ball, the economy might not work with its economic models, and the data it collects may not be accurate. In other words, the Fed might be driving blind. But even if all that is true, the Fed still needs to lead for markets to function, and leadership requires leaders to be credible with their followers. When leaders say that rates are going lower, rates are supposed to go lower. Some cannot go down, while others go up. If leaders say inflation will get back to target next time, they cannot keep moving the goalposts and blame it on lag effects.

Maybe the Fed just has smoke and mirrors, and its monetary policy is less effective today than market participants are led to believe and expect from it. But if that is true, it needs to find ways to stop advertising that it does not know any more than any other market participant what is ahead. It needs to stop going on record as consistently wrong.

Rule number one in the prediction business is the best way to not be wrong is to not say anything. If it cannot project to save its credibility, it should stop sending out dancing dot plots and telling bank treasurers that it is guided by wandering stars. Maybe channeling Alan Greenspan, a little constructive ambiguity would not be so bad.

The Bank Treasury Newsletter is an independent publication that welcomes comments, suggestions, and constructive criticisms from our readers in lieu of payment. Please refer this letter to members of your staff or your peers who would benefit from receiving it, and if you haven’t yet, subscribe here.

Ethan M. Heisler, CFA

Editor-in-Chief

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This Month’s Chart Deck

The Fed continues to work down its System Open Market Account (SOMA) holdings of U.S. Treasurys through its tapered Quantitative Tightening (QT) at around $25 billion per month. Since QT began in July 2022, it shrank its Treasury portfolio by $1.5 trillion, which brought its balance of Treasurys down to $4.3 trillion, or 12% of total Treasury debt outstanding. In 2022, before it began QT, it owned $5.7 trillion Treasurys, which equaled 19% of the total outstanding (Slide 1). Treasuries outstanding equaled $28 trillion when QT began, which now equals $36 trillion. Japan and China remain the most significant foreign Treasury holders, and together with other countries, they own $8.7 trillion of outstanding debt (Slide 2). Foreign investors are the largest holders of Treasurys, owning more than mutual funds and the Fed (Slide 3)..

Banks continue to scale out of consumer mortgage debt, both in securities and loan form (Slide 4), as non-bank competitors squeeze their profit margins. The trend is especially pronounced for large banks based on H.8 data when comparing residential mortgage loans and Agency MBS to total bank credit.

Capital markets remain vulnerable to stress scenarios. One potential sign of stress is the growth in daylight overdrafts, which reached the highest level since the onset of Covid (Slide 5). Traffic on FedWire is also growing, with nearly $2.5 trillion average daily value of transactions (Slide 6) .

The 10-Year Treasury sold off by 100 basis points since the Fed’s first rate cut in September 2019, which sent its term premium up to the highest level it has been at in more than five years (Slide 7).

According to a survey the New York Fed conducted last fall, more than half of the participants thought that U.S. fiscal sustainability poses the most disruptive risk to the financial system, followed by tensions in the Middle East, policy uncertainty, and a U.S. recession (Slide 8). They considered commercial real estate risk last on their risk of worries. When the New York Fed polled market participants last December, it found that the median projection for the yield on the 10-year Treasury is that it would fall below 4.0% this year. When it ran the poll, the 10-year yield was 4.2%, and this month equals 4.6%-4.7%. Longer-term, participants expected that the yield would average around 3.5% (Slide 9). Bank treasurers discount any chance that the Fed would cut rates at its meeting of the FOMC this month and are growing more skeptical by the day it will cut rates at the following FOMC meeting in March 2025 (Slide 10).