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Hawks Flock at the Fed

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The Federal Open Market Committee (FOMC) - the policy-setting arm of the Federal Reserve - made clear the intent to both raise rates and curb the size of the balance sheet in 2022. The statement released at the conclusion of the two-day meeting signalled that the Fed intends to raise rates “soon,” or as we expect, at its next meeting in March. The FOMC statement laid the groundwork for the Fed to begin to curb the size of its ballooning balance sheet not long after. Participants at the FOMC meeting were already discussing ways in which they might allow the balance sheet to shrink during the December meeting. The vote to signal rate hikes and a reduction in the balance sheet following a liftoff in rates was unanimous.

The risk on inflation has worsened since the Fed last met, with the consumer price index surprising on the upside again in December. The personal consumption expenditures (PCE) index for December, which the Fed focuses on, comes out on Friday of this week and will show a further acceleration in inflation.

Chairman Powell went out of his way to redefine the labor market as tight, despite the fact that employment is still below its February 2020 level. The key issue is that there are so many more job openings than job applicants, which means that there is room to cool demand without derailing employment gains. The job posting site Indeed.com showed some slowdown in job postings during the height of the Omicron wave in January but postings continued to outpace those looking for a job by a substantial margin. Job postings were still up more than 60% from February 2020; we have never seen anything like this in terms of the demand for labor.

It is rather remarkable that the Fed is actively debating how to reduce the size of its balance sheet, while still technically adding to its size until March. This was perhaps the most controversial part of the Fed’s decision. Many within financial markets were expecting the Fed to come to a more abrupt end to its asset purchase program. The Fed does not like to surprise financial markets and instead stuck to the decision it made in December to accelerate the end of asset purchases from June to March. The Fed could begin reducing the size of its balance sheet as soon as May. We are expecting the Fed to wait until June to begin reductions in its mammoth balance sheet.

Ultimately, the Fed would like to hold only Treasury bonds and not mortgage-backed securities. Powell underscored that the Fed is still debating how it will reduce the size of its balance sheet but underscored that it could achieve that much more rapidly than in the past. Many within the Fed would like to reduce the Fed’s holdings of mortgage-backed securities first. The Fed is more likely to allow its holdings of both mortgage-backed securities and Treasury bonds to mature at the same time.

The goal will be to put the balance sheet on remote control as it shrinks. The Fed wants reductions in the balance sheet to be predictable and akin to watching paint dry. Powell underscored that the Fed wants moves in short-term interest rates to be the “active tool” when it comes to policy decisions.

The Fed has discussed the role that the balance sheet can play in amplifying the effects of rate hikes. The loose consensus is that each $500 billion reduction in the size of the Fed’s balance sheet is expected to boost interest rates by about 25 basis points or 0.25%. Financial markets have already priced in several rate hikes by the Fed, which is why the 10-Year bond yield was already almost one-half of one percent above the low it hit of 1.34% on news of the Omicron variant on December 2, 2021.

Powell did underscore that there needs to be “substantial” reduction in the balance sheet. Atlanta Federal Reserve President Raphael Bostic has suggested that the balance sheet should start to drop by $100 billion per month. That said, there is no precedent for reducing the balance sheet and raising rates as the Fed has laid out. It would be fanciful to assume that reductions in the balance sheet will affect rates and the economy in a linear fashion. The risk is that we hit a tipping point, where balance sheet reductions and interest rate hikes work in tandem and have a larger impact than the Fed expects. The Fed will not know what that point is until we cross it.

For the moment, the Fed has concluded that variants are more inflationary than disinflationary because of the havoc they wreak on supply chains. The ongoing problems faced in the supply chain for computer chips, which is down from a median of 40 days to less than five, is the most serious example. Powell said that the Fed expects the economy to rebound after some Omicron-related weakness at the start of the year.

The role Omicron plays in further suppressing labor force participation is important, as it ups the ante that labor shortages could trigger a more vicious cycle of wage and price gains, even as it disrupts demand. The number of those out sick due to Omicron dwarfed anything we saw during previous waves, while exacerbating the rise in hospitalizations and deaths. More than 8.8 million people were out sick or caring for the sick according to the Household Pulse Survey in late December and early January. That is more than at any other time during the pandemic; the previous peak was 6 million in January 2021.

The Fed has a dual mandate: to foster stable inflation and full employment. That mandate cannot be achieved if inflation becomes entrenched. Powell has underscored that we need to have inflation under control to sustain the expansion. The Fed is taxed with the job of containing inflation and is now demonstrating its willingness to do so. That said, the Fed alone cannot cure what ails us. Our only true out is to escape the pandemic, which has thus far, proven elusive. The pandemic itself remains the largest downside risk to the outlook on the economy.

Bottom Line
The Fed has completed its pivot from being patient to panicked on inflation; its next move will be to raise rates. Soon after, it will be looking to reduce its massive balance sheet to amplify shifts in short-term rates and ease the transition for the broader economy. That sounds nice in theory but it has never actually been done. Making matters worse will be how heated the debate within the Fed gets as the FOMC decides how best to calibrate tightening. Brace yourselves for dissents and the dissonance that creates for financial markets in the year ahead.

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