– Powell Sees ‘Substantial’ Balance Sheet Shrinkage After Rate Hikes Begin
– Powell Says ‘Couple’ More Discussions Needed on Balance Sheet Reduction Strategy
– Powell Implies Rate Hikes May be More Aggressive Given High Inflation, Tight Labor
By Steven K. Beckner
(MaceNews) – The Federal Reserve took another giant step toward removing some monetary accommodation from an inflationary economy Wednesday.
Fed policymakers left short-term interest rates unchanged at the conclusion of their first two-day meeting of the year, but strongly signaled an initial hike in the key federal funds rate is coming at its next meeting in March after a two-year stay at the zero lower bound.
The Fed’s rate-setting Federal Open Market Committee also confirmed its intention to end asset purchases or “quantitative easing” in March, and Chairman Jerome Powell pointed toward “quantitative tightening” sometime after rate hikes get under way.
After discussing balance sheet policy for the second straight meeting, the FOMC released a set of “Principles for Reducing the Size of the Federal Reserve’s Balance Sheet,” but they were broad and general. A detailed plan for shrinking the $8.8 trillion balance sheet will come later.
Powell indicated the FOMC would need to put together something much more specific after another “couple” of meetings. Ultimately, he said, the Fed’s balance sheet would need to be reduced “substantially.” The FOMC statement said the balance sheet would be shrunk “significantly.”
In telegraphing the next step in monetary normalization, the FOMC declared it has met both the inflation and employment standards for raising the funds rate and and that it will “soon” be “appropriate” to start raising the funds rate.
The statement strongly implies the FOMC will raise the funds rate from the zero to 25 basis point target range at its March 15-16 meeting, by which time the Fed will have concluded its large scale asset purchases..
The FOMC set up liftoff by significantly modifying its policy statement. It reiterated that inflation has “exceeded 2% for some time.” But, in contrast to the Dec. 15 statement, which said it would be “appropriate” to leave the funds rate unchanged “until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment,” the FOMC now declares, “With inflation well above 2 percent and a strong labor market, the Committee expects it will soon be appropriate to raise the target range for the federal funds rate.”
On the quantitative side, the FOMC further accelerated the “tapering” of asset purchases, saying it will increase purchases of Treasury securities by $20 billion and agency mortgage backed securities by $10 billion in February. And it said it expects asset purchases to end “in early March.”
By saying a rate hike will be appropriate “soon,” the FOMC was clearly pointing toward a March 16 move – most likely of 25 basis points.
Powell declined to flatly predict a March rate hike, saying that decision would made at the next meeting, but told reporters, “the Committee is of a mind to raise the federal funds rate at the March meeting.”
Powell was also reluctant to say how much the FOMC will raise the funds rate, but seemed to suggest it could act fairly aggressively. He said he and his colleagues “are aware that this is very different expansion,” with “higher inflation, higher growth and a much stronger economy.”
“These differences are likely to be reflected in the policy we implement,” he added.
At the December meeting, FOMC participants projected at least three 25 basis point rate hikes this year, with more to follow in 2023, but since then, Powell said inflation has gotten “probably a little worse.” He said he is “inclined to raise my own estimate of PCE (inflation) a few tenths.”
Referring to the December rate projections, Powell noted the FOMC will publish new projections in March and remarked, “to the extent the (inflation) situation deteriorates further our policy will have to address that.”
Powell made clear he is not afraid higher rates will threaten the labor market, now that it’s been deemed to have reached “maximum employment.”
“There is quite a bit of room to raise interest rates without (hurting) the labor market,” he said. “This is a very very strong labor market .… My strong sense is that we can move rates up without severely undermining it.”
On a number of occasions, Powell said the Fed will need to be both “humble” and “nimble” in how it withdraws monetary stimulus.
Describing the Fed’s current policy course, he said, “This is going to be a year in which we move steadily away from the very highly accommodative monetary policy that would put in place to deal with the pandemic.”
“It’s going to involve a number of things. It does involve finishing asset purchases,” he said. “It’s going to involve lifting off. And it’s going to involve additional rate increases, as appropriate.”
“We’re going to write down in March our next assessment of what that might be,” Powell continued. “It’s going to continue to evolve as the day will evolve, we need to be quite adaptable in our understanding of this I think.”
“The last thing we’re going to do is we’re going to have a couple more meetings, I think, to talk about allowing the balance sheet to begin to run off, and do so in a predictable manner and that’s something that we’ll also be doing as appropriate,” went on.
“I don’t think it’s possible to say exactly how this is going to go and we’re going to need to be, as I’ve mentioned, nimble about this,” he added.
Powell again stressed that “the economy’s quite different this time…. The economy’s quite different, it’s stronger, inflation is higher, the labor market is much, much stronger than it was and growth is above trend even this year, let alone last year. So all of those things are going to go into our thinking as we make monetary policy.”
The FOMC statement was silent on when shrinking bond holdings will commence, but Powell has previously indicated doing so would happen much sooner than during the previous tightening cycle, when the FOMC waited three years from the time it stopped buying bonds to the time it started reducing the bond portfolio.
But the reappointed Fed chief indicated that, after the tapering of bond buying purchases has ended and rate hikes have begun, the Fed will begin to reduce its massive bond holdings “substantially.” That would be another way of tightening credit, which he said would operate “in the background” as the funds rate is increased.
Peppered with questions about when the Fed will start to shrink the balance sheet, Powell said he could not be specific, because the FOMC will discuss the matter at “a couple” more meetings, but he drew a contrast to the last time the Fed shrank its bond holdings starting in November 2017.
“The balance sheet is much bigger, of shorter duration than the last time,” he noted, adding that “the economy is much stronger, inflation is much higher.”
So he said the Fed could “move sooner than we did last time and also perhaps faster.”
Powell said “there is a substantial amount of shrinkage in the balance sheet to be done” and said “it’s going to take some time… we want that process to be orderly and predictable.”
“In terms of timing, I can’t really help you…,” he demurred, adding that the FOMC is “going to have another discussion at the next meeting and at least one more discussion at the meeting after that.”
Then, he promised the FOMC will make a more detailed announcement of how it intends to proceed – much like it did in 2017. As of now, he said “we haven’t made those decisions; we haven’t even had the important discussions we’ll have at coming meetings.”
Though hopeful inflation will receded, Powell continually emphasized that inflation risks are “to the upside,” and said the FOMC must “be in a position to address” those risks and “prevent higher inflation from becoming higher entrenched.”
Key to that, he said, is keeping inflation expectations “well anchored.”
Recently, there have been signs recovery from the pandemic is cooling – notably softer retail sales and industrial production. Soaring mortgage rates, reflecting rising bond yields, could dull the luster of the housing market.
Meanwhile, on Wall Street, concerns about monetary policy, the economy and geopolitical developments triggered a stock market sell-off, which saw the Dow Jones Industrials plunge more than 1,000 points at one stage Monday. Bond yields have also spiked in advance of the Fed decision. The 10-year Treasury note yield, which traded below 1.47% ahead of the December FOMC meeting, was trading above 1.8% Wednesday.
Nevertheless, the FOMC sounded upbeat optimistic in its characterization of economic conditions.
“Indicators of economic activity and employment have continued to strengthen,” it said.
“The sectors most adversely affected by the pandemic have improved in recent months
but are being affected by the recent sharp rise in COVID-19 cases.”
Echoing the December statement, the FOMC said, “job gains have been solid in recent months, and the unemployment rate has declined substantially.”
The FOMC also reiterated its appraisal of wage-price pressures, saying, “Supply and demand imbalances related to the pandemic and the reopening of the economy have continued to contribute to elevated levels of inflation.”
Powell drew attention to the fact that wages are jumping along with prices. “With constraints on labor supply employers are having difficulties filling job openings and wages are rising at their fastest pace in many years.
Despite recent upsurges in bond yields and declines in stock prices, the FOMC said, “overall financial conditions remain accommodative….” Powell indicated he is not particularly concerned about recent financial developments, although he said they are being monitored.
Notably, the FOMC removed the declaration of its long-standing commitment “to using its full range of tools to support the U.S. economy in this challenging time, thereby promoting its maximum employment and price stability goals.” But Powell uttered that rubric in his opening press statement.
With a fresh set of Federal Reserve Bank presidents rotating into voting position for 2022, Cleveland’s Loretta Mester, Kansas City’s Esther George and aft Louis’s James Bullard voted in favor. Standing in for the Boston Fed, which has not yet announced a replacement for Eric Rosengren, Philadelphia Fed President Harker also cast a vote in favor of moving toward a less accommodative monetary policy.
A 25 basis point hike, which is all that seems likely in March, would leave the funds rate far below the estimated “neutral” rate of 2.5%. And so far there is no plan to actively shrink bond holdings – only to stop adding to them. So it would be a misnomer to say the Fed is “tightening” monetary policy.
Underscoring that point, Powell said the Fed’s aim is merely to make monetary policy “less accommodative.”