Will Rising Oil Prices Impact Fed's Rate Hike Plan?
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In August, the Consumer Price Index (CPI) rose 0.6%, following a 0.2% rise in July. It was the most significant monthly increase in 14 months, with the recent surge in gasoline prices accounting for more than half of the rise. Excluding food and energy, the index rose 0.3%, compared to 0.2% in July. The shelter index continued its upward trend, marking its 40th consecutive month of gains, with the motor vehicle insurance and medical care categories also increasing. The price increases were partially offset by decreases in the indexes for lodging away from home, used vehicles, and recreation.
Headline CPI (Month % / Month%)
Inflation Rises to a 14-Month High as Gas Prices Increase
Market Not Surprised by Inflation Rebound
Oil prices have been in an uptrend for the past three months, with WTI climbing more than 20% since late June. Following the recent surge in oil prices, investors are left debating whether the oil rally will continue and cause inflation pressures to persist. Oil prices are highly idiosyncratic and influenced by complex macro and supply-demand dynamics, which makes forecasting oil prices difficult. Concerns about oil supply are driving prices higher and keeping oil strong from a technical perspective. However, it is worth noting that the narrative of higher oil prices is receiving much headline attention, and the market likes to prove the consensus trade wrong. Plus, oil prices historically decline as economic activity slows.
Focusing on whether rising oil prices will impact Fed policy
If the rally continues, it will likely keep headline inflation elevated. Is the threat of lingering inflation enough to keep the Fed raising rates? We doubt it. The Fed is highly focused on core inflation and knows it has little effect on oil prices. Plus, it's seeing progress in the data for shelter, used vehicles, and food. The market likes to talk in 'what ifs' and overanalyze new information, but we see the Fed placing less weight on oil prices if the current trend accelerates. While there is the potential for one or two more rate hikes, the Fed is still close to ending its tightening cycle. However, completing the rate hike cycle does not necessarily mean the Fed's balance sheet drawdown will end anytime soon.
Quantitative Tightening Continues
The Fed's quantitative tightening (QT) program continues to run in the background. The Fed's balance sheet is nearly $1 billion smaller than its April 2022 peak of $9 billion and sits at the lowest level since July 2021. While the Fed has pulled a large amount of liquidity out of the financial system, QT has yet to make a significant impact. Why? QT can pull liquidity out of the financial system from two sources: (1) bank reserves or (2) the Fed's reverse repurchase program (RRP).
Fed Balance Sheet
Quantitative Tightening Shrinks the Fed’s Balance Sheet
This is a notable change from 2022, when the combination of QT and rising interest rates pulled money out of bank reserves, which catalyzed the March 2023 bank turmoil. However, the capital in RRP is looking for a safe, short-term yield and a place to park excess cash (i.e., money market funds). Pulling liquidity out of RRP is significantly less disruptive than pulling it out of bank reserves. A decline in the Overnight Reverse Repurchase Agreement category indicates liquidity is being pulled out of RRP. In contrast, a decrease in the U.S. Net Liquidity Indicator indicates QT is pulling liquidity out of somewhere else, most likely bank reserves.
How Long Will the Fed Continue QT?
There was historically a view that interest rate policy and balance sheet policy should align. If the Fed was cutting interest rates, it shouldn't counteract that by also shrinking the balance sheet. However, that viewpoint has changed, with the Fed willing to run different policies. The Fed believes the banking system needs ~$2.5 trillion in reserves, defined as bank reserves plus RRP. Commercial banks had $3.1 trillion in reserves at the end of July, and RRP currently sits at $1.5 trillion, for a total of ~$4.6 trillion. QT's current monthly pace of $95 billion could run for another ~2 years until it reaches the Fed's target.
Important Disclosures
This material is provided for general and educational purposes only and is not investment advice. Your investments should correspond to your financial needs, goals, and risk tolerance. Please consult an investment professional before making any investment or financial decisions or purchasing any financial, securities, or investment-related service or product, including any investment product or service described in these materials.
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