Here’s how the Federal Reserve could shrink its $8.77 trillion balance sheet to fight high inflation, says a former Fed staffer

With the US inflation rate at a nearly 40-year high, Federal Reserve officials are expected to start trimming their balance sheet by $8.77 trillion sooner than they did the last time in 2017. to 2019, and at a pace that could be twice as fast.

That’s according to Roberto Perli, a former senior Fed official in Washington, who envisions an initial cut that starts at $20 billion a month for the first quarter, starting in June or September, and gradually increases to a $100 billion monthly pace by about the next one. year.

Although policymakers have yet to decide when or how quickly they will act this time around, Perli sees them following the basic plan of the previous episode, which involved using caps to set an upper limit on the rate of reductions. However, he says, the Fed will also be “ready to slow, pause or halt the contraction process at the first signs of market turmoil.”

Eight consecutive months of annual consumer price readings of 5% or more are putting pressure on the central bank to respond, with policymakers now bracing for a smaller toll, alongside rate hikes in the months to to come. Analysts are currently trying to imagine how such a twin-tightening process might play out, just as data on Wednesday showed consumer price hikes pushed the headline inflation rate year-over-year. 7%, a nearly 40-year high.

Read: As Wall Street watches yields climb, a big question arises: what is the “right size” for the Federal Reserve’s balance sheet?

Cornerstone Macro and Federal Reserve Board


“Nothing in the CPI report leads me to believe that the FOMC will be less inclined to move on the balance sheet in the direction I’ve described,” Perli said by phone.

Wednesday’s CPI report gives additional ammunition to policymakers such as Cleveland Fed Chair Loretta Mester, who said she supports the process of balance sheet reduction “as quickly as possible” without derailing markets. .

Minutes of the Fed’s Dec. 14-15 meeting, released Jan. 5, revealed that the policy-setting Federal Open Market Committee almost uniformly thought it would be appropriate to initiate a balance sheet liquidation at some time after the first rate hike. In a Q&A following the central bank’s December policy update, Fed Chairman Jerome Powell hinted that the second round would be different from when it launched in 2017, in saying that “the economy is so much stronger now” and that such differences should be taken into account. in the thinking of policy makers.

The Fed launched its current bond-buying program in March 2020, to help stabilize the U.S. government debt market at the onset of the COVID-19 pandemic – a move that ultimately led to a roughly doubling of the size of its asset portfolio in the last two years. Bond purchases, which keep long-term rates lower than they otherwise would be, help the economy by making it easier for consumers and businesses to borrow and spend.

How the Fed manages its portfolio may be more important than rate hikes, which may prove useless in controlling inflation until the central bank tries to reduce its holdings, some analysts say. .

Read: Forget about rate hikes. How the Fed manages its $9 trillion in assets is what really matters and The Fed assesses proposals for possible reductions in bond holdings

The Fed’s balance sheet reduction schedule “will be much more compressed this time and the pace of reduction should be faster given the better economic conditions and larger balance sheet size,” Perli, a Washington-based partner and global policy manager for Cornerstone Macro, and others wrote in a report dated Tuesday.

In particular, they see a relatively “short” lag of a quarter or two between the time of the initial Fed rate hike and the start of balance sheet contraction, compared to the seven quarters it took last time around. . With the FedWatch CME Tool reflecting a 74% probability of a 25 basis point hike in March, which would bring the target federal funds rate to 0.25%-0.5%, putting the start of quantitative tightening in June or September .

Cornerstone Macro also expects the pace of contraction to be about double that of 2017-19, given the toll is about twice as large as it was then, and will occur through what Perli describes it as “attrition only” or no asset sales. Assuming the contraction process is split between Treasuries and mortgage-backed securities, Cornerstone Macro estimates that the Fed will be able to eliminate $531 billion of Treasuries in the first five quarters of quantitative tightening. The amount of MBS runoff will depend on prepayments, which could be slow as higher interest rates make mortgage refinancing less attractive.

During the Fed’s cut cycle from 2017 to 2019, policymakers were trying to shrink the central bank’s balance sheet to a more normal size nearly a decade after the end of the 2008 financial crisis, and not out of fear of inflation.

On Wednesday, Treasury yields traded mixed after the CPI report. Meanwhile, the gap between 2-TMUBMUSD02Y,
0.902%
and 10-year rate TMUBMUSD10Y,
1.733%
shrunk to 82 basis points, like 7-TMUBMUSD07Y,
1.673%
and 10-year yields remained on the verge of reversing. The S&P 500 SPX,
+0.20%
and the Nasdaq COMP composite indices,
+0.24%
rose, although Dow DJIA industrials gave up gains in afternoon trading.

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