Hawks Flock at the Fed
By Diane Swonk, Chief Economist, Grant Thornton
The Federal Open Market Committee (FOMC) – the policy-setting arm of the Federal Reserve – made clear the intent to both raise rates and curb the size of the balance sheet in 2022. The statement released at the conclusion of the two-day meeting signalled that the Fed intends to raise rates “soon,” or as we expect, at its next meeting in March. The FOMC statement laid the groundwork for the Fed to begin to curb the size of its ballooning balance sheet not long after. Participants at the FOMC meeting were already discussing ways in which they might allow the balance sheet to shrink during the December meeting. The vote to signal rate hikes and a reduction in the balance sheet following a liftoff in rates was unanimous.
The risk on inflation has worsened since the Fed last met, with the consumer price index surprising on the upside again in December. The personal consumption expenditures (PCE) index for December, which the Fed focuses on, comes out on Friday of this week and will show a further acceleration in inflation.
Chairman Powell went out of his way to redefine the labor market as tight, despite the fact that employment is still below its February 2020 level. The key issue is that there are so many more job openings than job applicants, which means that there is room to cool demand without derailing employment gains. The job posting site Indeed.com showed some slowdown in job postings during the height of the Omicron wave in January but postings continued to outpace those looking for a job by a substantial margin. Job postings were still up more than 60% from February 2020; we have never seen anything like this in terms of the demand for labor.
It is rather remarkable that the Fed is actively debating how to reduce the size of its balance sheet, while still technically adding to its size until March. This was perhaps the most controversial part of the Fed’s decision. Many within financial markets were expecting the Fed to come to a more abrupt end to its asset purchase program. The Fed does not like to surprise financial markets and instead stuck to the decision it made in December to accelerate the end of asset purchases from June to March. The Fed could begin reducing the size of its balance sheet as soon as May. We are expecting the Fed to wait until June to begin reductions in its mammoth balance sheet.
Ultimately, the Fed would like to hold only Treasury bonds and not mortgage-backed securities. Powell underscored that the Fed is still debating how it will reduce the size of its balance sheet but underscored that it could achieve that much more rapidly than in the past. Many within the Fed would like to reduce the Fed’s holdings of mortgage-backed securities first. The Fed is more likely to allow its holdings of both mortgage-backed securities and Treasury bonds to mature at the same time.