Tim Duy’s Fed Watch, 4/5/22

Published on April 5, 2022
SGH Insight
...The direction of balance sheet policy is clear – the Fed is going to quickly ramp up to a high cap, we think $100 billion/month, but whatever the actual number, the intent will be to not get in the way of the roll-off of maturing assets such that the balance sheet organically normalizes over the next three years. Balance sheet policy magnifies the impact of rates policy:
The reduction in the balance sheet will contribute to monetary policy tightening over and above the expected increases in the policy rate reflected in market pricing and the Committee’s Summary of Economic Projections...

...Note that neutral may or may not be a stopping place, it is data dependent. The notion that the Fed can stop at neutral and look at what is going on could easily be overtaken by data that makes it clear that the Fed will need to push policy rates above neutral...

...An increase in rates as priced in markets is a clear indication that Brainard accepts the notion of a series of 50bp increases, at least two and maybe three or more if the data don’t provide relief by the middle of the year. I suspect the Fed consensus is pretty much committed internally to 50bp at each of the next two meetings and hoping the data allows for the Fed to recalibrate back down to 25bp after that point. I think market participants will feel pressure to price in additional 50bp rate hikes beyond two as long as inflation stays elevated and labor markets tight...

Market Validation
FOMC Minutes:

Some other participants noted that monthly caps for Treasury securities should take into consideration potential risks to market functioning. Participants generally agreed that monthly caps of about $60 billion for Treasury securities and about $35 billion for agency MBS would likely be appropriate. Participants also generally agreed that the caps could be phased in over a period of three months or modestly longer if market conditions warrant.

Participants also agreed that reducing the size of the Federal Reserve's balance sheet would play an important role in firming the stance of monetary policy and that they expected it would be appropriate to begin this process at a coming meeting, possibly as soon as in May...

...Participants judged that it would be appropriate to move the stance of monetary policy toward a neutral posture expeditiously. They also noted that, depending on economic and financial developments, a move to a tighter policy stance could be warranted...

...Many participants noted that—with inflation well above the Committee's objective, inflationary risks to the upside, and the federal funds rate well below participants' estimates of its longer-run level—they would have preferred a 50 basis point increase in the target range for the federal funds rate at this meeting. A number of these participants indicated, however, that, in light of greater near-term uncertainty associated with Russia's invasion of Ukraine, they judged that a 25 basis point increase would be appropriate at this meeting. Many participants noted that one or more 50 basis point increases in the target range could be appropriate at future meetings, particularly if inflation pressures remained elevated or intensified...

The Fed Is Only Becoming More Hawkish

Governor Lael Brainard’s speech today dispelled any lingering notions that she would lean against the hawkish direction taken by her colleagues. Expect the Fed to continue to accelerate along the path to neutral until the data breaks in a dovish direction.

As I anticipated, Brainard’s speech built out the narrative that inflation is an equity issue by highlighting the disproportionately negative impact of inflation on lower income socioeconomic groups:

Today, inflation is very high, particularly for food and gasoline. All Americans are confronting higher prices, but the burden is particularly great for households with more limited resources. That is why getting inflation down is our most important task, while sustaining a recovery that includes everyone. This is vital to sustaining the purchasing power of American families.

As far as policy implications go, Brainard notes that she is watching for the impact on services inflation of any consumer rotation away from goods:

High durable goods inflation reflects pandemic-related supply constraints as well as persistently elevated demand associated with the pandemic. I will be carefully monitoring the extent to which demand rotates back to services and away from durable goods, where it has remained consistently above pre-pandemic levels, and the extent to which the services sector is able to absorb higher demand without generating undue inflationary pressure.

If services inflation accelerates, the Fed will again ratchet up the hawkishness. She describes the Russian invasion of Ukraine as a “seismic” event that creates both upside risks for inflation and downside risks for growth. On that latter though:

That said, the U.S. economy entered this period of uncertainty with considerable momentum in demand and a strong labor market.

That means the Fed needs to focus on the inflation story for now. The Fed will be carefully watching the labor market and Brainard is hopeful pressures will ease later this year:

An increase in labor supply associated with diminishing pandemic constraints combined with a moderation in demand associated with tightening financial conditions, slowing foreign growth, and a large decrease in fiscal support could be expected to reduce imbalances later in the year.

Don’t read too much into this nod (or any others you might see) toward dovishness. Federal Reserve Chair Jerome Powell has already said the Fed is done making policy based on optimistic forecasts. Any hope of less tight labor conditions later this year will not prevent the Fed from tightening aggressively now. Indeed, Brainard was quite clear on the policy path:

It is of paramount importance to get inflation down. Accordingly, the Committee will continue tightening monetary policy methodically through a series of interest rate increases and by starting to reduce the balance sheet at a rapid pace as soon as our May meeting. Given that the recovery has been considerably stronger and faster than in the previous cycle, I expect the balance sheet to shrink considerably more rapidly than in the previous recovery, with significantly larger caps and a much shorter period to phase in the maximum caps compared with 2017–19.

“Methodically” is distinct from “measured,” as the latter term implies 25bp hikes and we aren’t likely to get a 25bp hike again until the second half of the year. And note the hawkish emphasis implied by the choice of adjectives. The direction of balance sheet policy is clear – the Fed is going to quickly ramp up to a high cap, we think $100 billion/month, but whatever the actual number, the intent will be to not get in the way of the roll-off of maturing assets such that the balance sheet organically normalizes over the next three years. Balance sheet policy magnifies the impact of rates policy:

The reduction in the balance sheet will contribute to monetary policy tightening over and above the expected increases in the policy rate reflected in market pricing and the Committee’s Summary of Economic Projections.

I think the implication here is that over time, the balance sheet reduction will lead to an increase in the term premium, which in turn will put upward pressure on the long end of the curve. That also serves as a basis for accelerating that process via asset sales if the Fed thinks it needs to get long rates higher faster, although there isn’t yet much appetite at the Fed for such a move. It also runs counter to any narrative that balance sheet run off will deliver tighter policy which raises more concerns about slower growth which in turn puts downward pressure on the long end.

Brainard expects pushing policy to a “more neutral” position this year:

I expect the combined effect of rate increases and balance sheet reduction to bring the stance of policy to a more neutral position later this year, with the full extent of additional tightening over time dependent on how the outlook for inflation and employment evolves.

Note that neutral may or may not be a stopping place, it is data dependent. The notion that the Fed can stop at neutral and look at what is going on could easily be overtaken by data that makes it clear that the Fed will need to push policy rates above neutral. 

Brainard embraces market pricing:

Our communications have resulted in broad market expectations for an expeditious increase in the policy rate toward a neutral level and a more rapid reduction in the balance sheet compared with 2017–19. Consistent with these expectations, we have already seen significant tightening in market financing conditions at longer maturities, which tend to be most relevant for household and business decision making. For instance, 30-year mortgage rates have increased more than 100 basis points in just a few months and are now at levels last seen in late 2018.

Looking forward, at every meeting, we will have the opportunity to calibrate the appropriate pace of firming through the policy rate to reflect what the incoming data tell us about the outlook and the balance of risks.

An increase in rates as priced in markets is a clear indication that Brainard accepts the notion of a series of 50bp increases, at least two and maybe three or more if the data don’t provide relief by the middle of the year. I suspect the Fed consensus is pretty much committed internally to 50bp at each of the next two meetings and hoping the data allows for the Fed to recalibrate back down to 25bp after that point. I think market participants will feel pressure to price in additional 50bp rate hikes beyond two as long as inflation stays elevated and labor markets tight.

I have been expecting the minutes to be hawkish. Not only did Brainard prime us to expect hawkish minutes, but other Fed speakers followed suit today. Via Bloomberg, Kansas City Federal Reserve President Esther George reiterated the importance of balance sheet policy in her outlook:

“I think 50 basis points is going to be an option that we will have to consider, along with other things,” George said in a Bloomberg News interview with Michael McKee on Tuesday. “We have to be very deliberate and intentional as we remove this accommodation. I am very focused on thinking about how the balance sheet moves in conjunction with policy-rate increases.”

George is probably the FOMC participant most open to the idea of outright asset sales. While the consensus view remains that the Fed can set the program on autopilot and manage by rates alone, that consensus might change. In a clear signal of just how hawkish the doves have shifted, San Francisco Federal Reserve President Mary Daly said that inflation is “as harmful as not having a job.” This seems to be an overstatement given that losing 10% of your real income from inflation is far from losing 100% from being fired. Still, for the public at large, everyone is affected to some degree by 10% inflation, while you are only directly impacted by unemployment if you are unemployed. Daly also warns that action on the balance sheet can start as soon as May. This is basically the same thing as saying it will happen in May. Look for some confirmation in the minutes.

Bottom Line: Barring some unforeseen negative shock, the Fed will step up the pace of rate hikes to 50bp increments starting at the next FOMC meeting. At the same time, the Fed will announce plans to trim the balance sheet. Until we see a turn in the data, we must expect the Fed will continue to hike in 50bp increments as it races to get policy to neutral as soon as possible without breaking the markets.

Back to list