Fed sets stage to raise rates beginning in March, and subsequently begin reducing balance sheet

*At its January 25-26 FOMC meeting the Fed kept the federal funds rate target unchanged at 0-0.25%, and in a move widely anticipated by markets suggested economic conditions warrant an imminent increase in the federal funds rate, setting the stage for liftoff in March. Alongside its policy statement, the Fed also published a statement outlining general principles that will govern future balance sheet reduction, although specific details with respect to pace and timing have been left to a future meeting. In line with market expectations, the Fed refrained from hastening the end of its large-scale asset purchase program, which will end in early March as announced by the Fed at its December meeting.

*The Fed’s Policy Statement pointed to a “strong labor market” and “inflation well above 2 percent” as factors that would justify an imminent increase in the federal funds rate, although interestingly the Fed refrained from explicitly characterizing labor market conditions as consistent with ‘maximum employment’ in its policy statement. Critically, Powell emphasized throughout his press conference that current economic conditions – which include historically tight labor markets, accelerating wage gains, and the prospects of prolonged supply constraints (Powell hinted semiconductor shortage will persist into 2023) – pose significant upside inflation risks.

*Currently, the fed funds futures market has built in more than four 25bp rate hikes in 2022, providing the Fed with the flexibility to raise interest rates over the next year without adversely surprising markets, with Powell also noting that markets pricing in balance sheet reduction later this year as being reflective of the success of the Fed’s forward guidance.

*The Fed’s statement on principles governing its balance sheet rundown outlined in broad strokes how the Fed is likely to approach reducing the size of its balance sheet, which would not occur until after the Fed has begun to increase interest rates. The Fed’s statement and Powell in his press conference stressed the importance of the federal funds rate as its primary active monetary policy tool and noted that reduction of the balance sheet would take place by adjusting the extent to which the Fed reinvests maturing assets. Notably, Powell indicated the pace and timing of balance sheet rundown could be faster than in the 2017-2019 episode, in part reflecting the current strength of underlying economic fundamentals.

*The Fed suggested it would prefer to primarily hold Treasury securities to minimize its impact on credit allocation, which points to a substantial planned reduction in its MBS holdings, which may be achieved by allowing MBS to run off the balance sheet at a faster relative pace than Treasuries, although the statement emphasizes balance sheet reduction will be measured and predictable. The optimal size of the Fed’s balance sheet remains an open question, but the Fed’s statement on balance sheet principles indicates reserves are expected to remain high enough to maintain an ample reserves regime.

*One of the factors Powell used to justify the Fed’s view that inflation will recede is the negative impulse of fiscal policy on economic activity in 2022, likely due to a reduction in the cyclically adjusted deficit. We caution against this view. While the government’s cyclically adjusted budget deficit will decline from its bloated 2021 amount, two factors suggest there is still significant fiscal stimulus in the pipeline. First, a substantial portion of deficit spending authorized by 2020-2021 legislation has yet to be spent. Deficit spending will continue to flow into the economy. Second, infrastructure spending will be ramping up, and as government investment, it will be calculated directly in GDP, and historically government investment involves a significantly higher fiscal multiplier than government transfer payments.

*The Fed’s Policy Statement and Principles for the Balance Sheet are very transparent, but Powell says inflation is coming down…suggesting the Fed is not prepared if inflation remains elevated (“OER, services prices, and inflation” January 18, 2022). Although Powell acknowledged the risk of higher and more persistent inflation in his press conference, and stressed the need for the Fed to maintain policy optionality to respond to the upside risks of inflation, the Fed has acted anemically and is still purchasing Treasuries and MBS even as headline CPI inflation is running at 7% yr/yr. This leaves the real Fed funds rate deeply negative and the Fed far behind the curve.

Mickey Levy, mickey.levy@berenberg-us.com

Mahmoud Abu Ghzalah, mahmoud.abughzalah@berenberg-us.com

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