Milton Friedman said in the 1970s, at the height of the Chicago School, that when a fool takes a shower he usually adjusts the temperature hastily and abruptly, disproportionately increasing the possibility of getting burned or freezing. With this metaphor he meant to warn about the dangers of monetary policy that is too aggressive or reactive, and how a central bank that tries to fix the economy too quickly can end up causing more harm than good. The idea put forward by the Nobel Prize winner is that political decisions aimed at changing the course of the economy should be implemented slowly and orderly rather than rushed.
The current chairman of the Federal Reserve, who is anything but stupid, is well aware of this problem. In the final stretch of his term, he is demonstrating breadth of vision by ignoring Donald Trump’s constant threats to drastically lower interest rates.
Jerome Powell prefers to moderate and has been planning a gradual process of withdrawing stimulus for some time, adapting it to the slowdown in the labor market and inflation at 3%. It began cutting rates in September 2024 and, after a pause in the first nine months of the year, already places the Federal Reserve’s low range at 3.75%. Furthermore, starting from December Quantitative Tightening will end and the Fed will stop reducing its balance sheet, a monetary restriction measure that has been implemented for three years and which has brought balance in terms of GDP back to pre-pandemic levels. This decision is now being adopted due to the sharp decline in bank reserves deposited at the Fed, which are at a five-year low – equal to three trillion dollars – and the tensions of recent weeks on the liquidity market.
The SOFR – the reference among financial institutions for overnight loans guaranteed by Treasury bills – has come to be quoted above the IORB – the interest rate on the Fed’s bank reserves – when it is logical and normal for the opposite to be true. In practice, monthly, 40 billion dollars will no longer be withdrawn from the financial system. All this through a new scheme with which it will offset the maturities of 35,000 million MBS – mortgage bonds – with Treasury bonds, adopting a neutral balance policy for the first time since the end of 2017.
The combination of this measure, together with the reactivation of the rate cuts implemented by the Fed in September, is good news for risky assets. While it is true that interest rate cuts are rare in prolonged economic cycles (since 1980 they have only occurred in 1985 and 1998), the historical average return over the next 12 months is usually 25%. In short, and returning to Friedman, hot water is better than too hot, and go slowly and safely so as not to burn yourself.
