Fed Plans “Rapid” Balance Sheet Reduction and Interest Hike as US Inflation Hits 7.9%
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Fed Plans “Rapid” Balance Sheet Reduction and Interest Hike as US Inflation Hits 7.9%

The Fed might begin a reduction of its balance sheet by May in a bid to address surging inflation in the US.
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Federal Reserve Governor Lael Brainard has said the Central Bank could begin a “rapid” reduction of its balance sheet as soon as next month. The measure, along with interest rate hikes, comes in response to surging inflation, which is currently running at its fastest pace in 40 years.

Meanwhile, the news spooked investors and induced a market-wide selloff, sending major averages considerably lower on the day while the 10-year Treasury yield jumped to the highest in three years. 

Fed to Begin “Rapid” Balance Sheet Reduction to Control Inflation

Lael Brainard, who is awaiting Senate confirmation to become the next Fed vice-chair, said Tuesday that the Fed would resume increasing rates steadily and will also start balance sheet reduction by May. Brainard, who normally favors loose policy and low rates, said the move is necessary in order to address surging inflation. 

“Currently, inflation is much too high and is subject to upside risks. The [Federal Open Market] Committee is prepared to take stronger action if indicators of inflation and inflation expectations indicate that such action is warranted.”

Markets expect the Central Bank to sort out a plan at its May meeting for the reduction of some of its $9 trillion balance sheet, which is primarily consisted of Treasurys and mortgage-backed securities. In a prepared speech, Brainard emphasized that the process will be swift. 

“The [FOMC] will continue tightening monetary policy methodically through a series of interest rate increases and by starting to reduce the balance sheet at a rapid pace as soon as our May meeting.”

As reported, US inflation reached 7.9% in February, a far cry from the Fed’s long-term target of about 2%. This level is already the highest in 40 years, but analysts don’t expect a retrace any time soon. For one, UBS Senior US Equity Strategist Nadia Lovell expects the consumer price index to hit 8.5% in March.

The current high inflation is largely attributed to the global supply chain crisis caused by the COVID-19 pandemic. However, economists believe other factors, including the unprecedented level of spending from the passage of COVID-19 relief programs, poor monetary policies, and turmoil in the labor market, have also played an important role.

The Fed has already taken some measures to control rising inflation. In mid-March, the central bank announced its first rate hike in more than three years, a 0.25 percentage point move. However, recent comments by Brainard suggest the central bank could double the pace at which the federal funds rate is raised. 

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What Would Shrinking the Balance Sheet Mean for the Economy?

Generally, the Fed shrinking the balance sheet is comparable to a rate hike. That is because when the central bank buys bonds (quantitative easing), interest rates move down, which encourages lending and thus expands the economy. And when it sells bonds (quantitative tightening), the opposite is expected to happen.  

However, there is no insurance that the move from QE to QT would have the same economy-cooling effect as a rate increase. The Federal Open Market Committee also mentioned this point in the minutes from its December meeting:

“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.”

Meanwhile, another view suggests the move from QE to QT directly affects liquidity, not rates. That is because QE pushes money into the system, while QT pulls it out. When there is more money, investors favor speculative assets more. On the contrary, when there is less money, they turn to safe assets such as Treasuries. 

The Fed creates more demand for Treasuries by selling them, sending rates down. Meanwhile, what effect the liquidity change has on the real economy is unclear. However, it is worrying as this could tighten right into a recession.

Data Suggest US Economy Could Go Into a Recession

It is worth noting that the 10-year/2-year yield curve, the difference between the 10-year treasury rate and the 2-year treasury rate, is on the cusp of inversion. Historically, a negative 10-year/2-year curve has been viewed as an indicator of an upcoming recession.

However, the 10-year/3-month curve, the difference between the 10-year treasury rate and the 3-month treasury rate, which is usually a more powerful recession predictor, is still wide. As of now, this suggests no recession, but it may just be a matter of time before this curve also inverts. 

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