A Volcker-esque Fed

Members of the Federal Open Market Committee (FOMC) voted unanimously to raise rates another half-percent at the conclusion of their meeting today and to begin the process of reducing the Federal Reserve’s bloated balance sheet. The Fed left the door open to additional half-percentage point rate hikes in the meetings to come. Fed Chairman Jay Powell said there is a broad sense on the committee that “additional 50 basis point increases should be on the table for the next several meetings.”

The Fed decided to phase in reductions in its balance sheet over three months, starting in June. This is consistent with what the Fed discussed at its last meeting in March. The Fed will reach its target of $95 billion in balance sheet reductions per month - $60 billion in Treasury bonds and $35 billion in mortgage-backed securities (MBS) and agency debt - in August. That is twice the pace and much sooner than we saw in the 2010s.

There is no consensus about how much balance sheet reductions will amplify short-term rate hikes. Mortgage rates have already moved up more rapidly than Treasury bond yields on fears the Fed could sell additional parts of its MBS portfolio before rate hikes are done. Rapid moves in mortgage rates have a much larger effect on the housing market, notably home values, than slower movements in rates.

There is no road map on how to more rapidly reduce the balance sheet. In some ways, balance sheet reductions are akin to driving in reverse using the rear view mirror; you never know what obstacles you might hit in the process. Buckle up. The road ahead is unpaved and littered with potholes.

The Fed knows it is behind the curve on inflation. The first step is to get rates rapidly to neutral, which it thinks is between 2 and 2.5%, although no one knows for sure.

The next decision is how high to go beyond neutral to bring down inflation. The last forecast the Fed provided had a 3% terminal rate. Powell underscored that “if higher rates are required, we will not hesitate to deliver them.”

The Fed has had to make a tough decision. Either risk a more prolonged and entrenched inflation or hammer demand more aggressively to come down to meet a supply-constrained economy. The Fed has chosen the latter.

Powell has included the labor market as a target of rate hikes. He argued in mid-March that he would like to see the ratio of job openings per unemployed worker return to the levels we saw before the onset of the pandemic. Back then, job openings per worker were a little more than one-to-one.

He stressed that job openings hit a record-breaking 1.9 openings for every worker in March. That is not sustainable. Job openings are now nearly 60% above the levels before the onset of the pandemic in February 2020; we do not have 40% more workers than we did back then. That means we need to hammer the demand for workers and raise the supply of workers via higher unemployment to bring the two back into alignment.

When pressed on whether the Fed could achieve a soft landing - a slowdown in inflation without an increase in the unemployment rate - Powell said that, in theory, there was a path to get there. He also admitted that he expects this to be very challenging, not very easy and to some extent, dependent on events outside of the Fed’s control.

We now expect the Fed to raise rates to 2.5%, pause a bit and then resume rate hikes. We expect the Fed to hit 3.25% before the rate hiking cycle is over but, as Powell stated, the Fed may need to raise rates more aggressively.

What would stop the Fed from raising rates more aggressively? Additional shocks to demand could come from the war in Ukraine and geopolitical tensions. There is also the risk of spillover effects. Bank balance sheets, especially in developing economies, may look better than they actually are, given moratoriums on loans to blunt the effect of the pandemic. This is in addition to a global surge in sovereign debt.

The Fed is the default central bank to the world. Every time it raises rates, developing economies are pressed to match those moves to defend their currencies and prevent a larger surge in inflation. That makes their debt harder to service.

Bottom Line
The Federal Reserve has begun an aggressive credit tightening cycle, likely the most aggressive since the 1980s. Powell stressed his hope that he could achieve a soft or “soft-ish” landing, but said that he and his colleagues would not hesitate to raise rates even higher than they expect if necessary. That suggests the Fed is much more focused on inflation than unemployment, and willing to accept a rise in unemployment. External factors could represent the tipping point for a recession. Either way, Former Fed Chairman Paul Volcker would be pleased.

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