FOMC preview: Rate hikes and balance sheet reduction are up next

Next week’s Federal Open Market Committee meeting will kick off an extraordinary two months of policy decisions by the Federal Reserve in which we expect the central bank to hike its policy rate by 100 basis points. These rate increases, starting with a 50 basis-point increase on Wednesday. will occur as the Fed simultaneously embarks on the long-awaited reduction in its balance sheet, which we think will shrink by nearly $3 trillion through the end of 2024, from $8.93 trillion today. The Fed has prepared investors and the public for this moment, which has partially resulted in the yield on the 10-year Treasury to increase by roughly 75 basis points to the current 2.87%. We anticipate that the Federal Reserve by the end of the year will have increased its policy rate to at least 2.5%, which in our estimation is restrictive terrain and will result in a slowing in overall economic growth back toward its long-term trend of 1.8%. As for the drawdown, the Fed has indicated that it will reach $60 billion per month in Treasury securities and $35 billion per month and mortgage-backed securities. While we would be a bit more aggressive and push the drawdown to at least $100 billion per month over three years, the Fed will almost surely phase in its drawdown starting midyear. This process will most likely start with monthly caps of approximately $40 billion for Treasury bills and $25 billion for mortgage-backed securities. In addition, the Fed, sensitive to inflation, will retain the flexibility to increase or decrease the monthly caps contingent on economic and employment dynamics. Various members of the Fed have implied that a drawdown of roughly $3 trillion should equate to an increase of 50 basis points in long-term rates. Their comments have already resulted in rising rates along the maturity spectrum and higher 30-year mortgage rates, so there should not be more than the traditional knee-jerk reaction in longer-term rates following Wednesday’s announcement and release of its policy statement. We also anticipate a modest change to the paragraph in the Fed’s statement that concerns growth, which in March led off the policy announcement. Instead of saying, “Indicators of economic activity and employment have continued to strengthen,” the committee will most likely alter that language to state something like: “Indicators of economic activity remain solid despite the contraction in growth during the first three months of the year even as employment remains strong.” Elsewhere in the policy statement, we do not anticipate much change, including the paragraph acknowledging risk to the outlook linked to the Russian invasion of Ukraine.