The Federal Reserve on Wednesday signaled that it intends to use both conventional and unconventional tools to address risks to the economic outlook caused by inflation even as the economy remains short of full employment.
The major changes to the Federal Open Market Committee statement released after the FOMC’s meeting imply that policy normalization will soon be in full swing with a rate increase in March that will almost surely be followed by three to four additional hikes this year.
Jerome Powell said that there is quite a bit of room to increase rates without impairing the labor market.
The key change in the statement is: ”With inflation well above 2% and a strong labor market, the committee expects it will soon be appropriate to raise the target range for the federal funds rate.”
While the central bank chose to maintain its current policy rate between a range of zero and 25 basis points, the changes to the statement all point to a shift in policy despite pervasive uncertainty linked to the pandemic.
In his news conference, Federal Reserve Chairman Jerome Powell noted that the Fed remains data dependent and that its policy is not on a fixed path. He also noted that there is quite a bit of room to increase rates without impairing the labor market.
If price stability is a precondition for maximum sustainable employment, then the changes in the statement and Powell’s comments sent a clear signal that the central bank intends to reduce the size of its balance sheet. The Fed is still discussing how to do that.
In a separate statement on balance sheet reduction, the committee agreed that it is appropriate at this time to provide information regarding its planned approach
While the timing and pace have yet to be determined, the committee expects that it will begin after it starts increasing the target range for the federal funds rate.
A possible scenario
In our estimation, that may look a little like the following: In July, following what we expect to be the second rate hike of the year in June, the Fed should begin a phased-in drawdown of the balance sheet with $30 billion in Treasury bills and $10 billion in mortgage-backed securities per month that will increase by $10 billion and $5 billion per month respectively. By the end of November, that rate of drawdown would reach a total of $100 billion per month.
The Fed sent a clear signal that it intends to reduce the size of its balance sheet.
This gradual approach would then allow the central bank to engage in a strategic pause in its rate hikes following what we believe will be a third rate increase in September and just before a possible fourth in December.
Doing so would represent a $450 billion net reduction in the balance sheet by the end of the year. Continuing at the $100 billion monthly pace would result in a net $1.65 trillion roll-off by the end of next year and $2.85 trillion by the end of 2024.
That would reduce the overall balance sheet by the end of 2024 to roughly $5.9 trillion, which is above the $4.1 trillion it held in February 2020, before the pandemic. We do not anticipate that the Fed will return to the levels of before the pandemic.
The policy pivot embedded in both the FOMC statement and Powell’s comments should be organized around creating expectations that point to increases in the policy rate this year and a balance sheet runoff that will facilitate an increase in longer-term rates to cool an economy running hot and, on the margin, inflation.
The reintroduction of duration risk into the market will be on the minds of investors as the economy slows. The question is, how long and how much damage to the economy and employment conditions will be wrought before the Fed obtains its objectives?
Monetary policy works through the expected path of interest rates, which point to four rate hikes this year with a fifth possible. While there is roughly a six-month lag before rate hikes work their way into the real economy, expectations have already resulted in a de-facto tightening of financial conditions and the onset of what is likely to be two to three years of policy normalization.
