- The Fed will begin reducing its balance sheet by midyear.
- Expect a roll-off of $2.85 trillion by the end of 2024.
- The roll-off can be put on hold if economic conditions merit.
- The Fed is unlikely to sell assets back into the market under current conditions.
Risks to the economic outlook from inflation have prompted the Federal Reserve to shift toward a tighter monetary policy with increases in its policy rate and the unwinding of its asset purchases.
The reduction of the Fed’s balance sheet may end up challenging the conventional wisdom that the central bank will raise its policy rate four times this year.
But one underexplored area of Fed policy is how it plans to reduce its $8.78 trillion balance sheet while maintaining the flexibility to respond to changing economic conditions and craft a soft landing for a heated economy.
It’s a method of tightening that is little understood, but it may end up challenging the conventional wisdom that the Fed will raise its policy rate four times this year as both inflation and growth ease in the second half of the year.
Here’s how it works: As the Federal Reserve reduces its balance sheet, that in turn will put upward pressure on long-term rates. At the same time, the Fed will retain the flexibility at the short end of the curve to carefully manage the pace and magnitude of increases in the policy rate.
The logic here is that modestly higher long-term rates result in a reduced need to hike rates at the front end of the curve.
This approach is one reason we forecast the 10-year Treasury yield ending the year at 2.25%. Factors like demographic changes, reduced returns on investment, a global savings glut and a long-term growth rate of roughly 2% will all continue to dampen longer-term rates despite the current policy challenge of inflation.
One of the central bank’s primary policy objectives is to obtain price stability, which it defines as a 2% average inflation target. Over the medium term, that serves as a pre-condition for the private sector to increase hiring to the point at which the economy has obtained full employment. The Fed’s current implied definition of full employment, the second part of its dual mandate, stands at 4%.
But a more elastic definition of what constitutes full employment, one that includes employment levels of underrepresented portions of the population, is likely more consistent with 3.5% or lower.
The uncertainty surrounding what exactly constitutes price stability and full employment lies at the heart of concerns that, with inflation standing at 7%, the Fed may do too little or too much in hiking the policy rate and end up either with a longer-term problem with inflation or killing off the recovery.
The primary economic objective is for the Fed to bring inflation back toward its flexible average inflation target of 2% while simultaneously engineering a reduction in growth back toward its long-term pace of 1.7% without overshooting and causing a recession.
This is the primary reason why we think that the Fed will begin to use its balance sheet to address the inflation challenge now.
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 will stop purchasing assets by mid-March. 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.
That will result in creating a steeper yield curve and cool excess and speculative demand in the housing market. 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.
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.
We expect the Fed to phase in the size of its balance sheet run-off with the ultimate goal of $100 billion per month.
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.
What might that look like today? We expect the Fed to phase in the size of its balance sheet run-off with the ultimate goal of $100 billion per month through the end of 2024 or earlier based on the judgment of the central bank in the direction of inflation, employment and growth.
In our estimation, this should start in July following what we expect to be the second rate hike of the year in June with $30 billion in Treasury bonds and $10 billion in mortgage-backed securities per month. That will increase by $10 billion and $5 billion per month, respectively, which would reach $100 billion per month by the end of November.
A phased-in introduction of quantitative tightening will then enable the central bank, if it determines, to engage in a strategic pause in the rate hike portion of its policy normalization process following what we believe will be a third rate hike in September and just before a possible fourth rate hike in December.
Doing so would represent a $450 billion net reduction in the size of its balance sheet by the end of the year. Continuing at a $100 billion 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 would be above the total in February 2020, before the pandemic, of $4.1 trillion.
Any idea that the Fed is going to reduce its balance sheet back to the levels of before the financial crisis or before the pandemic should be gently discounted. The balance sheet will remain a policy tool during this business cycle and those that follow.
By embarking on the reduction of its balance sheet in the near term, the Fed will signal its commitment to the public, fiscal policymakers and investors that it does not intend to tolerate inflation running hot for more than a short period of time.
Rate hikes at the short end of the curve have little power to provide relief for inflation headaches caused by supply chain constraints. The primary target of its policy change is the management of medium- to long-term inflation expectations, which continue to remain just at or above its target of 2%.
Causing the economy to slow and unemployment to increase through larger than necessary increases in the policy rate is decisively suboptimal. Instead, the Fed is going to turn to its balance sheet to address the near-term challenges presented by inflation without wreaking overall havoc through the anvil of rate hikes.
This method, which is not well understood outside of elite decision-making and banking circles, will create the conditions for the central bank to obtain its primary economic objective of a soft landing from above-trend growth without causing a recession.