Fed will shrink balance sheet ‘quickly’, says Brainard

The Federal Open Market Committee (FOMC) is expected to shrink its balance sheet “significantly faster than in the previous rally,” according to Federal Reserve Governor Lael Brainard in a speech on April 5, 2022. paramount importance in bringing inflation down,” she said.

The size of the Fed’s balance sheet was a record $8.9 trillion as of the week of March 28, 2022. That’s more than double the range of about $4.4 trillion that has been held from mid-2014 to early 2018, and is also up sharply from a recent low of around $3.8 trillion in mid-2019.

In the “previous recovery” referred to by Brainard, which was in 2017-2019, the Fed let its balance sheet shrink by about $50 billion a month. Markets anticipate that the rate of reduction this time around will be about double that amount. Indeed, the March 15-16, 2022 FOMC meeting minutes, which were released a day after Brainard’s speech, indicate that members are generally in favor of setting the initial monthly rate of balance sheet reduction at about $95 billion.

Key points to remember

  • Fed Governor Lael Brainard indicated in a speech that the Fed was preparing to reduce its balance sheet “rapidly” to control inflation.
  • It expects the balance sheet reduction to be much larger and faster than in 2017-19.
  • Minutes from the March FOMC meeting, released a day later, reveal a growing consensus in favor of rapid balance sheet reduction.
  • Market indicators indicate that the Fed should also raise interest rates sharply in 2022 and 2023.

Brainard’s key points

To bring inflation down, Brainard said the FOMC would continue to “methodically” tighten monetary policy through a series of interest rate hikes and beginning to shrink the balance sheet at a “rapid pace” at its next meeting, May 3. -4. It expects much larger caps and a much shorter period to phase in the maximum caps compared to the 2017-2019 period.

Brainard’s discussion of the caps indicates that the FOMC plans to shrink its balance sheet not by selling bonds, but rather by not reinvesting some of the major payments received when the bonds mature. These caps are the limits that the FOMC will set on the amounts that will not be reinvested each month. It expects the combined effect of interest rate hikes and balance sheet shrinking to move monetary policy to a more “neutral” (i.e. less stimulative) stance by end of 2022.

Brainard noted that the extent of further monetary tightening over time will depend on how the outlook for inflation and employment changes. Indeed, she notes that the U.S. economy has entered the current period of uncertainty (due in large part to Russia’s war on Ukraine and its far-reaching impacts) with “tremendous demand momentum.” and a strong labor market”.

March FOMC Meeting Minutes

A day after Brainard’s speech, on April 6, 2022, the FOMC released the minutes of its meeting held on March 15-16, 2022. All of the options presented by the staff for reducing the balance sheet called for more “trickle down”. faster than that experienced in 2017 -19. Indeed, all participants agreed that high inflation and a tight labor market warrant starting the balance sheet runoff at a future meeting, with a faster rate of runoff than in 2017-19.

Participants generally agreed that monthly caps (i.e. maximum liquidations or reductions) of about $60 billion for Treasury securities and about $35 billion for asset-backed securities Mortgages (MBS) would probably be appropriate. Participants also generally agreed that caps could be staggered over three months or perhaps a bit longer if market conditions warrant. Several participants indicated that they would be comfortable with relatively high monthly caps or no caps at all.

Market expectations

Markets expect interest rate hikes at each of the next six FOMC meetings in 2022, which could represent a cumulative hike of 2.5 percentage points. Among Fed officials who favor faster balance sheet reduction and rate hikes is Esther George, president of the Federal Reserve Bank of Kansas City. “I think 50 basis points is going to be an option that we’ll have to consider, as well as other things,” she told Bloomberg TV on April 5.

On the morning of April 7, 2022, the CME FedWatch Tool assigned a 78.8% probability of a 50 basis point rate hike at the May FOMC meeting and a 21.2% probability of a 25 basis point hike. basis points. As of April 5, 2022, the Federal Reserve Bank of Atlanta’s Market Probability Tracker estimated that the market expects a federal funds rate of approximately 2.64% by December 2022 and 3.15% by June 2023 .

The CME FedWatch tool and the Atlanta Fed Market Probability Tracker are based on complex analyzes of securities whose prices are determined by expectations about interest rates in general and FOMC policy movements in particular.

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