Projected Fed Rate Cuts May Lead to ‘Income Drag’ Similar to 2020, Says Mike Dolan

By Mike Dolan

LONDON (Reuters) – While some might worry that potential interest rate cuts by the Federal Reserve could overly stimulate the already thriving U.S. economy, it’s also important to consider the impact of reduced income from the banking system.

A surprising consequence of the Fed’s ongoing easing cycle could be a decrease in cash income, mirroring how rapid rate hikes two years ago positively influenced these deposits. The previous rate increases seemed to mitigate some negative impacts of rising borrowing costs on the overall economy, suggesting that lower rates might similarly diminish any economic gains.

Strategists at Morgan Stanley have analyzed the income boost that Federal Reserve rate hikes provided, alongside the forthcoming drag from rate cuts. They highlight that historical models of central bank policy often overlook this new dynamic.

In contrast to past practices, the Fed currently pays significant interest to commercial banks for the reserves it holds. This reserve volume surged during the central bank’s balance sheet expansions following the 2008 financial crisis and again during the COVID-19 pandemic. Although excess reserves have decreased in the past year, they remain substantial at around $3.1 trillion.

Additionally, the Fed’s reverse repo facility, which serves to absorb what it deems excess liquidity, still operates at nightly volumes of approximately $300 billion to $400 billion, although this is less than one-fifth of its former peak.

Moreover, a sizable portion of the more than $6 trillion in money market fund assets is invested in U.S. Treasury bills with maturities of one year or less. These investments, which have benefited from rising interest rates, are now poised to generate less attractive returns.

The sharp interest rate hikes from 2022 to 2023—amounting to a 5 percentage point increase in the fed funds rate—boosted interest income across these channels, lessening the effects of the intended borrowing restrictions. Therefore, a reduction in rates could potentially dampen market liquidity and cash income, even as borrowing costs decrease.

Morgan Stanley strategists note, "Just as higher interest income may have muted the tightening effects of monetary policy, lower payments may similarly reduce the effects of easing. If the Fed had to raise rates more than necessary to offset this dynamic, it may need to cut rates more aggressively as well."

BACK TO NEAR-ZERO RATES?

To gauge the potential income drag, the Morgan Stanley team has estimated the monthly income impact if the Fed lowers rates to what it identifies as a "neutral" rate of around 3% over the next two years. Their analysis reveals that the overall impact as a percentage of projected GDP could be comparable to the effects seen when the Fed brought rates to near-zero in 2020.

This drag could influence various factors, including bank profits, lending activity, corporate cash reserves, and overall wealth effects. Whether this will counterbalance the lower borrowing costs remains to be seen.

However, this potential headwind to Fed easing might be appropriate as the central bank looks to adjust policy towards a stable equilibrium, particularly given the economy’s resilience.

The income drag could provide a necessary check against excessive stimulus, similar to how tightening was cushioned by the benefits it provided to many cash-rich firms and affluent households.

Yet, if the Fed struggles to gain traction with interest rate cuts due to an economic shock or renewed deflationary pressures, it may find itself easing more than anticipated.

The previously unlikely scenario of returning to near-zero rates may not be as improbable as previously thought in the post-pandemic context. Concerns about inflation dropping too low are already surfacing in various regions, including Europe and parts of Asia.

This situation could complicate the Fed’s "quantitative tightening" strategy as U.S. commercial bank reserves hover around what is considered a "steady state." Many analysts predict that the Fed will conclude its balance sheet reduction efforts by next year.

If the income drag from rate cuts becomes a significant issue, discussions about concluding quantitative tightening may intensify, prompting further scrutiny of monetary policy direction.