The Federal Reserve sets the wheels in motion to reduce its balance sheet

The Federal Reserve, at its December meeting, began to consider starting to reduce the amount of bonds it holds, with members saying a balance sheet reduction will likely begin some time after the central bank begins to increase. interest rates, according to the minutes released Wednesday.

While officials have not determined when the Fed will start disbursing the nearly $ 8.3 trillion in treasury bills and mortgage-backed securities it holds, statements from the meeting indicated that the process could start in 2022, maybe in the next few months.

“Almost all of the participants agreed that it would likely be appropriate to initiate the balance sheet runoff at some point after the first increase in the target range for the federal funds rate,” the meeting summary reads.

Market expectations currently are that the Fed will start raising its benchmark interest rate in March, which would mean that balance sheet reduction could begin before the summer.

The minutes also said that once the process started, “the appropriate pace of bankruptcy would likely be faster than it was during the previous episode of normalization” in October 2017.

The size of the Fed’s balance sheet matters as central bank bond purchases were seen as a key element in keeping interest rates low while stimulating financial markets by maintaining cash flow.

Wall Street reacted negatively to the news, with stocks falling and government bond yields rising in the run-up to a Fed tightening in 2022.

Fed officials said repeatedly during the meeting that they believe the super-easy policies instituted at the start of the Covid-19 pandemic are no longer justified or justified. Addressing the main pillars of their dual goals, committee members expressed concern over soaring inflation while saying they see the labor market close to full employment.

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“They did more than talk about it. Obviously, there was a fairly long discussion. It was a pretty serious conversation, ”said Kathy Jones, chief fixed income strategist at Charles Schwab, of the minutes, which had a special section titled“ Discussion of policy standardization considerations ”.

“The fact that almost all of the participants agreed that it was appropriate to initiate the balance sheet runoff after the first increase in the federal funds rate target range implies that there is not a great appetite for ‘let’s wait. to see, ”Jones added. “The last time they waited two years. This time it looks like they’re ready to go.

During this 2017-19 reduction, the Fed allowed a monthly capped level of proceeds from the bonds it holds while reinvesting the rest. The central bank started by authorizing $ 10 billion in treasury bills and mortgage-backed securities each quarter, increasing by the same amount each period until caps hit $ 50 billion.

The program aimed to significantly reduce the balance sheet but was bypassed by the weakness of the global economy in 2019, followed by the pandemic crisis in 2020. In total, the reduction is only about $ 600 billion. . Former President Donald Trump was a vocal critic of the program, sometimes referred to as “quantitative tightening,” as he lambasted Fed officials.

Rate hikes, tapering off

As expected, the Fed’s decision-making group after the December meeting kept its benchmark interest rate near zero. However, officials also said they were forecasting up to three-quarters of a percentage point increase in 2022, along with three more hikes in 2023 and two more the following year.

Meeting officials said inflation indicators “have been higher and more persistent than expected,” the minutes said. While members said they believe growth will be “robust” in 2022, they also said inflation poses a significant risk, perhaps even more so than the pandemic.

Therefore, they said it would be time to tighten the policy sooner than expected.

“Some participants felt that a less accommodating future policy would probably be warranted and that the committee should express a firm commitment to deal with high inflationary pressures,” the minutes said.

In this sense, the committee announced that it would step up the pace of its monthly bond purchase program. Under the new plan, the program would now end around March, after which it would release the committee to start raising rates.

Current federal funds futures market prices indicate a 2-to-1 probability that the first hike will occur in March, according to the CME. FedWatch Tool. Traders believe the next increase will come in June or July, followed by a third move in November or December.

Fed officials have indicated that the reasoning behind the measures was a response to higher and more persistent inflation than they had imagined. Consumer prices are rising at their fastest rate in almost 40 years.

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