MNI INTERVIEW: Aggressive Fed Risks Liquidity Squeeze-Hoenig

The Federal Reserve risks triggering a sharp and sudden tightening of credit conditions in coming months as it tightens aggressively to make up for lost time, former Kansas City Fed President Thomas Hoenig told MNI.

The Fed has upped its pace of rate hikes at every meeting so far this year, increasing by 25 bps in March after standing pat in January, then by 50 bps in May and 75 bps in June. It is widely expected to deliver another 75 bps at next week’s meeting.

“I don’t think people appreciate just how far behind the curve they were and remain. And I don’t think people appreciate that the so-called tightening phase didn’t really start until May or June, because the first move was so insignificant,” said Hoenig, who expects the Fed to tighten into a likely recession. “You will see a liquidity squeeze of some significance and that will further assure us of a significant financial constraint here in the next few months.”

MNI reported last week that Fed officials are worried about an abrupt tightening of financial conditions that they are trying to fine tune with two blunt and imprecise tools – rate increases and asset runoffs to shrink a USD9 trillion balance sheet. (See MNI: Fed Fears Financial Tightening May Speed Up -Ex-Officials)

“I’ve seen some argue that because the balance sheet is so large and the reserve base is so big that the banks will lend. To the extent that they have lines of credit that they have to honor they will lend, but that’s temporary and I think they are as nervous as anyone,” said Hoenig, also former vice chair of the Federal Deposit Insurance Corporation.

“They are both implementing rate hikes and QT, which they’ve also just started. So you’re going to have this real significant tightening effect,” he said.

Separately, Atlanta Fed economist Bin Wei told MNI the effects of QT are not linear -- they could be amplified by market strains. (See: MNI INTERVIEW: Fed Says Market Strains Could Ramp Up QT Effect)

FLYING BLIND

Complicating the Fed’s attempts to calibrate its tightening are doubts over the level of the neutral rate of interest and the overarching need to catch up to headline inflation figures that hit another 40-year high of 9.1% in June.

“It’s been the Fed's tendency now that they are so far behind to keep tightening until they actually see inflation come down significantly and that usually means to go too far to the upside,” Hoenig said.

Policymakers think the neutral rate is somewhere around 2.5% and therefore intend to push fed funds to around 3% or a bit higher before possibly reconsidering the outlook.

“If they don’t know where to put rates they’re going to be flying blind and they’re going to tend to say, this inflation, we’ve got to break it and they’re going to keep going until they create some kind of – I hate to say the word crisis, but some kind of significant financial constraint.”

HOLDING THE LINE

Another major challenge for the Fed will be to rebuff likely political pressure to reverse course and cut rates as unemployment begins to rise. Hoenig expects the jobless rate will climb from current historic lows of 3.6% to at least 5%, but also thinks the Fed will need to raise interest rates to at least 4% and then keep them there for the foreseeable future in order to rein in inflation.

“If you do create a real constraint on the economy as soon as things start to slow down and unemployment starts to rise, then the pressure will mount extremely to reverse policy. This is a pattern of the 1970s, it’s the pattern of the Fed’s history,” Hoenig said.

“So their real challenge is not whether to move 75 or 100 basis points, the challenge is finding that number and then staying there until the lags catch up – and have a recession and not create a liquidity crisis that leads to panic.”