January minutes accentuate Fed’s hawkish pivot, few new details on balance sheet reduction

January minutes accentuate Fed’s hawkish pivot, few new details on balance sheet reduction

*January’s FOMC meeting minutes highlight the Fed’s mounting concerns over inflation amid tightening labor markets, accelerating nominal wages, and inflation that is running at multi-decade highs. Crucially, the January meeting was held prior to the release of January’s employment report and CPI, both of which surprised to the upside. In particular, payroll employment gains firmed, suggesting labor markets largely brushed off the impact of the omicron variant and tightened further, while January’s CPI print revealed a further broadening of inflationary pressures into core inflation categories.

*Consequently, while markets have ascribed a more dovish tilt to the meeting minutes, reflected in a moderation in the number of rate hikes priced in by fed funds futures markets, this may prove to be too sanguine an outlook. The Fed’s minutes made clear that “most participants noted that, if inflation does not move down as they expect, it would be appropriate for the Committee to remove policy accommodation at a faster pace than they currently anticipate.” Indeed, a couple of FOMC participants advocated ending asset purchases sooner to establish credibility.

*January’s minutes, continuing a trend established through much of the latter half of 2021, included further upward inflation forecast revisions from Federal Reserve Board Staff, who now see PCE inflation rising to 2.6% in 2022, up 0.5pp from their forecast of 2.1% from the prior month.

*While many had hoped the January minutes would provide further details on the Fed’s deliberations on its balance sheet, few were forthcoming with specific details on the timing and pace of balance sheet reduction to be discussed at later meetings. However, on the basis of the minutes and the statement released in January on principles that would guide the Fed’s balance sheet reduction, it is clear FOMC participants favor a more aggressive balance sheet reduction than during the prior episode from 2017-19, with committee members citing the strength of underlying economic fundamentals today relative to the prior period of balance sheet reduction. Moreover, the minutes and balance sheet principles statement clearly outline the Fed’s preference to adjust the composition of its balance sheet in the long term away from MBS and toward treasuries, which may require active sales of agency MBS.

*Details of the minutes also indicate FOMC participants remain concerned over stretched asset valuations. Several participants noted “asset valuations [are] elevated across a range of markets” and are concerned “a major realignment of asset prices could contribute to a future downturn”, while other participants pointed to healthy household and business balance sheets, and a “well-capitalized and liquid banking sector” as factors underpinning financial system resilience. This suggests the FOMC may ‘see through’ an orderly correction in asset valuations provided the impact on real economic activity and financial system stability is modest.

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

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

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