In its last meeting, the Fed increased interest rates by 25 basis points for the first time since 2018, raising the fund target range to 0.25-0.50%, and signaled six more rate hikes in 2022. The minutes of the Fed March meeting showed that “many” officials would prefer to raise rates by half a point rather than a quarter-point move, but decided not to do so in light of Russia’s invasion of Ukraine. The Federal Reserve has signaled it will cut its massive bond holdings at a maximum of $95 billion per month, while raising interest rates to cool the hottest inflation in four decades. If we look at the prominent details in the minutes;
· Participants generally agreed that an upper limit of approximately $60 billion per month for Treasury securities and approximately $35 billion for MBS would be appropriate. (The last time the Fed shrunk its balance sheet from 2017 to 2019, the highest tranches of $50 billion per month were used.)
· Participants also generally agreed that caps could be implemented gradually over a three-month period, or modestly longer if market conditions permit.
· Participants agreed that significant progress has been made in the plan and that the Committee is in a good position to begin the process of reducing the balance sheet size soon after the end of its May meeting.
· Many respondents indicated that they would prefer a 50 basis point increase in the target because inflation is well above the Committee’s target, inflationary risks are on the upside, and federal funds rates are well below participants’ projections for the long-term level. However, in light of the greater short-term uncertainty regarding the Russian invasion of Ukraine, they decided at this meeting that a 25 basis point increase would be appropriate.
· Participants agreed that it would be appropriate to quickly shift the monetary policy stance towards a neutral stance.
· Most respondents agreed that it would be appropriate to redeem coupon securities up to the cap each month and Treasury bills in months when coupon principal payments were below the cap.
Regarding the May meeting;
The FOMC is expected to approve the balance sheet cut at its next meeting on May 3-4. The move to shrink the balance sheet will widen a sharp turn towards fighting inflation as the Fed bought bonds last month as it tried to softly reduce its support for the pandemic. In other words, a more effective QT will be realized compared to the rate hike. Reducing the size of their balance sheet, which has risen to $8.9 trillion by aggressively buying bonds to protect the economy from Covid-19, will also help tighten financial conditions. However, it will take time for this to bring the balance sheet down to the pre-pandemic period, considering the $95 billion monthly and $1.14 trillion annual tranches from the System Open Market Account. At this rate, the balance sheet drops to $4.3 trillion in 43 months (pre-pandemic). Therefore, it is possible that the Fed will increase the upper limit in 3-month evaluations by directly selling long-term bonds while melting the stock of 326 billion dollars of short-term Treasury bills. The minutes include multiple ending scenarios ranging from slower to faster.
The faster it moves here, the tighter the liquidity conditions will be. Therefore, the Fed will be able to increase these limits to a limited extent in order to prevent the financial system and credit mechanism from causing an economic recession. Even between 2017-19, the upper limit was 50 billion dollars.
System Open Market Account Domestic Securities… Source: Federal Reserve Bank of New York
If we look at how the economy entered this tightening; The consumer price index rose 7.9% in February, the fastest since 1982. Meanwhile, US labor markets remain strong as employers added 431K jobs and the unemployment rate fell to 3.6% last month. March’s strong labor market report paves the way for the FOMC to take decisive action against inflation. The Fed’s determination to return inflation to its target of around 2% calls for faster action. The prolongation of the war is, of course, a risk for the growth of the economy, but it is also a great risk for the growth of inflation. And inflation can affect pricing and consumer behavior and cause demand and production shocks. Of course, these effects should be avoided.
The market continues to coalesce around two main themes: the Ukraine war and tight monetary policy, but market sentiment has grown around the idea of rising interest rates. Fed hawks face an increasingly uncertain küresel backdrop. Reports of the Russian invasion of Ukraine oscillate between escalation and de-escalation. Peace talks between Russia and Ukraine have also helped to calm some frayed nerves. However, while the developments regarding the Ukraine war are quite uncertain, the impact on inflation and thus central bank policy is quite evident.
The minutes are hawkish as it gave way to a 50 basis point rate hike in May, kept another 50 basis point increase on the radar for June, and a balance sheet reduction plan. After the March FOMC, where they were timid and avoided a 50 bps increase, policy makers observed that the Russian invasion of Ukraine pushed up food and energy prices. Then they said they could move faster in policy, and Fed presidents brought up 50 bps rate hikes in their latest statements. In his statements, Powell declared that a half-point increase, if necessary, was on the table for May 3-4. Investors have priced in the possibility of more than seven rate hikes in 2022 as inflation pressures spread, and they see the probability of the Fed increasing rates by half a point next month at about 85%.
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