The Fed’s Road to Full Normalization

With inflation still well above the U.S. Federal Reserve’s target and the unemployment rate now below estimates for the long-run maximum level, the Fed reiterated recent guidance following its January meeting: Officials expect to hike the policy rate in March, kicking off a series of four rate hikes in 2022. Although the Fed’s near-term rate trajectory indicates a sooner and more rapid rise in response to inflationary risks, we haven’t changed our expectation that a still-low neutral rate, larger central bank balance sheet, and generally higher economy-wide debt levels will keep the terminal level of this rate hiking cycle at or even below that achieved in 2018 (i.e., a range of 2.25%–2.5%).

Meanwhile, Fed officials signaled an earlier start to winding down the central bank’s balance sheet (a process known as quantitative tightening or QT) by releasing a list of balance sheet policy principles, which provided some high-level information about the Fed’s plan for a significant reduction in assets held. While officials didn’t provide additional details on the pace or likely start to the program, we expect it to begin around midyear (following the end of asset purchases in early March), when the fed funds rate is expected to be above 0.5%.

Accelerating the timetable

Since the previous FOMC (Federal Open Market Committee) meeting in mid-December, a surprisingly strong December employment report prompted Fed officials to once again pull forward expectations for liftoff from the current 0%–0.25% fed funds rate. The 3.9% unemployment rate is now below FOMC estimates for its long-run level (a proxy for maximum employment), and inflation has significantly overshot the Fed’s longer-term target (2% PCE, or personal consumption expenditures). Although headline inflation levels are expected to moderate this year, the strong labor market recovery and resulting pressures on wages were likely key factors behind the Fed’s plan to remove policy accommodation. We believe the Fed is targeting a more neutral stance in order to position policy for elevated inflation risks.

To this end, the Fed used the January meeting – the last meeting before expected liftoff in March – to formally signal an upcoming rate hike by amending the forward guidance section of the January FOMC statement to say it will “soon” be appropriate to raise rates. The March rate hike is likely to kick off a sequence of quarterly rate hikes and the beginning of QT later this year, given Fed Chair Jerome Powell’s comment at the press conference that it will soon be appropriate to “steadily move away” from the current highly accommodative monetary policy.

50 basis point hike – a bridge too far?

While Chair Powell reiterated FOMC expectations for a sequence of rate hikes, he stopped short of hinting that a 50 basis point rate hike is likely in March (although he didn’t rule it out, either). While Chair Powell confirmed that the committee believes it has achieved the labor market and inflation benchmarks needed to begin the rate hiking cycle, inflation is still expected to moderate over the coming quarters, likely reducing the need for an abrupt adjustment at the March meeting.

Nevertheless, Chair Powell reiterated that the FOMC will be quite attuned to the risk that the inflation process is moving higher – something that tends to happen when wage hikes lead to greater price hikes, which lead to further wage hikes, and so on. Although aggregate wage pressures have accelerated as labor markets tighten, the balance of evidence still suggests that the currently elevated level of headline inflation will moderate as pandemic-related frictions in labor and product markets moderate over time.

Balance sheet outlook: Sooner start, faster decline

As expected, the Fed announced an early-March end to its asset purchase programs, while further signaling its intent to begin to reduce its balance sheet soon by releasing the list of principles mentioned above. The December FOMC meeting minutes suggested that asset holdings would likely begin to decline sooner and at a faster pace this cycle relative to last cycle, although Chair Powell stated that additional discussions on the details of any program will be addressed at upcoming meetings. Nevertheless, despite the more aggressive approach, the Fed also reiterated its preference for a passive reduction, instead of outright sales in the secondary market.

Based on this guidance, we expect the Fed to announce the passive reduction in its balance sheet by ceasing its reinvestment of proceeds from maturing U.S. Treasuries and agency mortgage-backed securities (MBS). We also expect the Fed to set higher caps for Treasury coupon and MBS reinvestment relative to last cycle, which would target a faster balance sheet decline over the coming years. Indeed, we estimate this would allow the Fed to reduce the size of its balance sheet by over $1 trillion by the end of 2023 – a much faster pace of decline than what was achieved in the 2017–2018 cycle. Nevertheless, with the size of the balance sheet currently around $4 trillion higher than pre-pandemic levels, the Fed will still have a long way to go before it achieves a full normalization.

Tiffany Wilding and Allison Boxer are economists and regular contributors to the PIMCO Blog.