The Federal Reserve is preparing to launch the next phase of its policy normalization by drawing down its balance sheet as soon as May to boost rates out along the maturity spectrum and to keep inflation expectations anchored, minutes of the Federal Open Market Committee’s March meeting show.
That reduction may be as large as $95 billion per month as securities are allowed to run off the balance sheet. Fed officials generally agreed to a cap of $60 billion from Treasury bills and $35 billion from mortgage-backed securities. The reduction could also eventually involve the possible sales of mortgage-backed securities.
In our estimation, it would be preferable to phase in the balance sheet caps with a target of $100 billion per month to provide some flexibility in case the economy unexpectedly unwinds in the face of geopolitical risks and if financial conditions tighten too much.
The minutes, released on Wednesday, indicate that a hawkish Fed is also ready to lift rates by 50 basis points in one or more meetings as the central bank accelerates its policy normalization process.
One interesting aspect of the minutes is that some participants would have preferred to hike rates at the March meeting but did not because of the Russian invasion of Ukraine. The minutes, however, imply that the idea of four or more 50 basis-point hikes is not likely.
Given the near certainty that the consumer price index and the policy-sensitive core personal consumption expenditures deflator will move above already elevated levels over the next few months, investors, firm managers and policymakers should prepare for higher interest rates along the entire rate curve.
The central bank is moving to create the conditions—slower growth, moderating resource demand and likely higher unemployment—to bring down unacceptable levels of inflation. While that will most likely take the better part of this year, next year and 2024, that is the suboptimal policy mix that the Fed will have to implement for the foreseeable future.
Possible policy design
So how will drawing down the balance sheet put upward pressure on long-term rates and bring inflation back toward the target?
Rather than purchasing assets to increase the size of its balance sheet and support economic expansion through lower long-term rates, as the Fed has done throughout the pandemic, the central bank will reverse that process by allowing the balance sheet to shrink, which some refer to as quantitative tightening. We do not anticipate that the Fed will sell assets back into the private market under current conditions.
In technical terms, the central bank has done this to address the financial crisis and the pandemic by removing duration risk in the private sector (purchasing assets) to reduce long-term rates.
With inflation now a primary concern, the central bank has stopped purchasing assets, lifted the federal funds policy rate and will most likely lift that rate by an additional 50 basis points at its May and June meetings. It will then allow the maturing assets to simply run off the balance sheet.
By doing this, the central bank is simply adding duration risk back into the private sector, which will permit higher longer-term rates.
On the margin, higher interest rates at the long end of the curve will dampen inflationary pressures that are now moving into the cost of shelter and what is called owners’ equivalent rent inside the consumer price index.
Left unattended, that type of inflation will prove stickier and more difficult to reverse absent a recession. It’s why now is the time to use the balance sheet tool to address inflation.
An example
What will the timing and magnitude of such a policy look like? A look at how the Fed addressed this between 2017 and 2019 is instructive.
In the previous business cycle, the Fed, once it was convinced the economy was at or near full employment and inflation was not an issue, capped its balance sheet reductions at an easily recognizable and digestible pace for fixed income investors to avoid any unnecessary disruption or overreaction.
From 2017 to 2019, the central bank capped the maturing assets to roll off its balance sheet at $50 billion per month—$30 billion in Treasury bills and $20 billion in mortgage-backed securities.
This time around, we are getting a clearer picture of how the Fed will handle the balance sheet reduction as it seeks to tame surging inflation that is the highest in four decades.
