Fed Gets Religion on Inflation

The Federal Reserve is scheduled to meet this week. Brace for a one-half percent rate hike and an announcement on how the Fed plans to reduce its bloated balance sheet. In March, the Fed agreed to a phased-in reduction of the balance sheet over the course of three months. They would like to see a runoff of $95 billion per month - $60 billion in Treasury bonds and $35 billion in mortgage-backed securities (MBS).

Governor Lael Brainard has said that she expects the Fed to announce balance sheet reductions in May but not actually begin until June. That would mean that we would have to wait until August before the Fed achieved its initial runoff goal of $95 billion per month.

The timing of this meeting in early May means that there is a window to start the process of reducing the balance sheet sooner. That would get us to full runoff in the Fed’s balance sheet in July instead of August. It would also send a stronger signal on its commitment to fighting inflation.

Why wouldn’t the Fed do that? The balance sheet is a bit of an economic quagmire. There is no consensus on how much more changes in the balance sheet will raise rates. Mortgage rates have already spiked in response to expectations that the Fed will reduce its balance sheet. The Fed has also discussed selling part of its MBS portfolio.

There is concern that the law of unintended consequences could kick in. The Fed wants to tighten credit conditions, not trigger a seizure in credit markets. That said, it is behind the curve on inflation and ready to move aggressively; a more compressed timeline would achieve that. Otherwise, it is left walking a tightrope of raising rates and reversing course on the balance sheet, while not triggering a meltdown.

Look for reporters to press Chairman Jay Powell on whether the Fed can achieve its goal of 2% inflation without triggering a recession. Many within the Fed have voiced their skepticism about achieving a soft landing at this late stage of the game.

Even Powell has said the landing could be “soft-ish” instead of “soft.” The two are not the same. “Soft-ish” includes an increase in the unemployment rate that is essentially like a mild recession, even if growth does not slip into negative territory for the obligatory two consecutive quarters.

The consequences and urgency to deal with inflation were even more apparent with earnings announcements last week. Even the largest tech behemoths are feeling the pinch of higher costs and supply chain disruptions. The pivot from goods into spending on services has also taken a toll on online retailers.

The moral of the story. The Fed is about to act on its promises and that action will be swift. It will raise rates and move to reduce its balance sheet. It could accomplish what needs to be done by raising short-term rate hikes alone but that would raise other questions about symmetry. If the balance sheet helped ease credit conditions, it should be reduced to tighten credit conditions. That sounds good on paper but there is no road map for doing this. We live in an interesting time. I could use a dose of boring.

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