The surprise
Just after the initial meeting Chairman Jerome Powel indicated that The Federal Reserve is planning to cut economic support faster by tapering bond purchases and possibly raising interest rates in 2022, more than what was expected before the meeting. The Fed minutes (Minutes of the Federal Open Market Committee or FOMC) released on January 5 revealed not only the details made public in the initial Fed statement on December 15, but also significant discussions regarding reduction in Fed bond holdings in the coming months that were not disclosed previously. Some members of the FOMC were arguing that reductions in Fed’s balance sheet could start after the central bank begins raising interest rates, therefore, likely in the middle of 2022 – much sooner than in previous cycles of quantitative easing-tightening. Note: The Federal Open Market Committee meeting minutes are a detailed record of the committee’s policy-setting meeting, held about two weeks earlier. The minutes offer detailed insights regarding the FOMC’s stance on monetary policy, so currency traders carefully examine them for clues concerning the outcome of future interest rate decisions.
Why are changes in the Fed balance sheet important?
To put it simply, runoff of bonds and MBS (mortgage-backed securities) would mean the destruction of money. Because the only way to destroy the money is to return the loan (for more about this phenomenon see Riksbank report) and bonds are essentially loans. Thus, it would mean considerably tightening monetary policy against a loose monetary policy, which markets got accustomed to in the last two years. Another element markets are worried about, as stated in the Fed minutes, is that it is much harder to predict the consequences of monetary tightening as well as quickly reverse it (see Key takeaways from Fed minutes at the bottom of this article). This is because if central banks raise the interest rate it doesn’t automatically mean that the amount of money on the market has changed; only that the cost of borrowing has changed. Thus, by allowing bond runoffs, the central bank reduces the amount of money circulating in the economy. Therefore, such central bank discussions indicated to the markets that the Fed is preparing to fight inflation on all fronts. During the 2017-2019 reductions the Fed allowed part of proceeds from the bonds to roll off each month while reinvesting the rest. It increased runoff from $10 billion to $50 billion at the end of the program. Note: Portfolio runoff is a general concept in portfolio management that describes situations where assets decrease. Runoff can occur for a variety of reasons including the maturation or expiration of securities, liquidation of certain assets, or any other situation where assets decrease or are withdrawn from a portfolio. The Fed instituted three rounds of bond-buying after the 2008 financial crisis that exploded its balance sheet from around $800 billion to more than $4.5 trillion at one point. The idea, called quantitative easing, was to knock down long-term interest rates to resuscitate the housing market and to provide needed liquidity for the financial system. Since then the Fed’s balance sheet ballooned to $8.3 trillion. To increase the money supply, the Fed will purchase bonds from banks, which injects money into the banking system. It will sell bonds to reduce the money supply. Although, letting bonds runoff is a less aggressive tightening policy by Feds compared to outright selling bonds in the open market.
Tighter monetary policy effects on markets
Tighter monetary policy can affect markets in multiple ways. If Feds would aggressively reduce the amount of MBS and bonds it would somewhat tighten banks’ balance sheets, thus, in turn, would almost surely raise mortgage rates and, subsequently, cool the housing market. As well as 11 of 13 monetary tightenings were followed by recessions (Figure 1). Rising interest rates would make bonds more attractive as an investment alternative to other groups of assets, namely gold, stocks, and, likely, bitcoin because less money going into bonds is expected to lower their prices and raise their yields. Moreover, it would increase the cost of raising capital for high-flying growth stocks as well as affect highly indebted companies by the rising cost of debt. Furthermore, it would reduce speculation on the stock market with borrowed money. Lastly, higher interest rates mean future profits are worth less today, and that’s hurting fast-growing technology stocks. Owing to the reasons mentioned above, tech heavy stocks on the NASDAQ experienced their largest drop in 11 months on Wednesday. But it might be too early to panic because of how addicted the overall economy is to cheap money, hence interest rate hikes might taper before shifting into high gear.
The Fed’s mandate
The Federal Reserve has a dual mandate: it sets inflation targets, to ensure price stability, which in turn creates a stable economic environment that can foster the goal of maximum employment. It is assumed that in a predictable price environment companies can make the best long-term economic decisions which in turn guarantees stable economic growth and a healthy labor market. At least since 1996, the US Federal Reserve has used monetary policy with the aim of keeping inflation at 2%— the goal that was reiterated in the latest Fed minutes. After President Biden picked Powell for the second term to lead the Federal Reserve, he indicated a tougher approach to dealing with inflation. In large part, because opinion polls show that high inflation is not well received by the majority of Americans, in fact, 88% said they are worried about high inflation. No wonder, as October’s annual US inflation rate stood at 6.2% as measured by CPI (Consumer Price Index derived by US Bureau of Labor Statistics). Americans have not seen such high inflation in more than 30-years. The second part of the Fed mandate is maximum employment, which is full employment minus the natural level of unemployment. It means that anyone who can work should be able to find a job but at the same time, unemployment is not too low and is not causing wages to rise too fast which would perpetuate high inflation. It is assumed such a natural unemployment level to be 4-5%. New unemployment reading last week showed it falling to 4.2%, almost at par with the pre-pandemic level.
Key takeaways from the Fed minutes
Participants began a discussion of a range of topics associated with the eventual normalization of the stance of monetary policy.The contributors generally emphasized that, as in the previous normalization episode and as expressed in the Committee’s Statement on Longer-Run Goals and Monetary Policy Strategy, changes in the target range for the federal funds rate should be the Committee’s primary means for adjusting the stance of monetary policy in support of its maximum-employment and price-stability objectives. This preference reflected the view that there is less uncertainty about the effects of changes in the federal funds rate on the economy than about the effects of changes in the Federal Reserve’s balance sheet. Moreover, participants stated that the federal funds rate is a more familiar tool to the general public and therefore is advantageous for communication purposes. A few participants also noted that when the federal funds rate is away from the effective lower bound (ELB), the Committee could more nimbly change interest rate policy than balance sheet policy in response to economic conditions.Participants remarked that the current economic outlook was much stronger, with higher inflation and a tighter labor market than at the beginning of the previous normalization episode. They also observed that the Federal Reserve’s balance sheet was much larger, both in dollar terms and relative to nominal gross domestic product (GDP), than it was at the end of the third large-scale asset purchase program in late 2014. Some participants judged that a significant amount of balance sheet shrinkage could be appropriate over the normalization process, especially in light of abundant liquidity in money markets and elevated usage of the ON RRP facility.Participants had an initial discussion about the appropriate conditions and timing for starting balance sheet runoff relative to raising the federal funds rate from the ELB. They also discussed how this relative timing might differ from the previous experience, in which balance sheet runoff commenced almost two years after policy rate liftoff when the normalization of the federal funds rate was judged to be well underway.Almost all participants agreed that it would likely be appropriate to initiate balance sheet runoff at some point after the first increase in the target range for the federal funds rate. However, some judged that the appropriate timing of balance sheet runoff would likely be closer to that of policy rate liftoff than in the Committee’s previous experience. They noted that current conditions included a stronger economic outlook, higher inflation, and a larger balance sheet and thus could warrant a potentially faster pace of policy rate normalization. Some participants commented that removing policy accommodation by relying more on balance sheet reduction and less on increases in the policy rate could help limit yield curve flattening during policy normalization. A few of these participants raised concerns that a relatively flat yield curve could adversely affect interest margins for some financial intermediaries, which may raise financial stability risks. However, others referenced staff analysis and previous experience in noting that many factors can affect longer-dated yields, making it difficult to judge how a different policy mix would affect the shape of the yield curve.Many participants judged that the appropriate pace of balance sheet runoff would likely be faster than it was during the previous normalization episode. They also judged that monthly caps on the runoff of securities could help ensure that the pace of runoff would be measured and predictable, particularly given the shorter weighted average maturity of the Federal Reserve’s Treasury security holdings.Participants also discussed the composition of the Federal Reserve’s asset holdings. Consistent with the previous normalization principles, there was a preference for the Federal Reserve’s asset holdings to consist primarily of Treasury securities in the longer run. To achieve such a composition, some participants favored reinvesting principal from agency MBS [mortgage backed securities] into Treasury securities relatively soon or letting agency MBS run off the balance sheet faster than Treasury securities.
