Fed Nods To March Hike, Sketches QT With Runoff ‘Principles’

Inflation in the world’s largest economy is still “elevated,” the January FOMC statement said. That’s due in part to “supply and demand imbalances related to the pandemic and the reopening of the economy.”

That (somewhat euphemistic) description was unchanged from the language employed in December, when the Fed jettisoned the much maligned “transitory” characterization on the way to citing “inflation developments” in explaining a decision to accelerate the wind down of monthly asset purchases.

Some market participants suggested the Fed might announce a hard stop to QE at the January meeting rather than letting the program expire in line with the implied schedule from the December meeting. Those out-of-consensus calls weren’t realized, but the Fed did explicitly commit to “bringing them to an end in early March.”

The discussion now centers around when and how the Fed will begin the process of reducing the balance sheet, which ballooned to $9 trillion as monetary policy worked overtime in the wake of the pandemic (figure below).

Plainly, stocks have benefited from the liquidity tsunami.

In addition to the policy statement, the Fed released a set of “principles” (no Ray Dalio jokes) for running down the balance sheet. “The Committee expects that reducing the size of the… balance sheet will commence after the process of increasing the target range for the federal funds rate has begun,” the press release said. So, QT won’t begin in March. That much we know. The policy rate, not the balance sheet, is the primary means of adjusting monetary policy, the Fed reiterated.

Recall that the release of the December meeting minutes was the proximate cause of January’s stock correction. As I wrote at the time, the minutes were more explicit than expected regarding the runoff discussion. It’s been a rough ride since then (figure below).

The market now expects QT to begin in June, or May at the earliest. Traders are keen on any details around runoff caps and other technicalities, including whether the Fed will treat MBS differently.

Any new nods to active selling from SOMA (as opposed to passive runoff) would be greeted as hawkish, although as ever, the market reaction depends on how effective officials are at socializing the message. On Wednesday, the Fed said that the Committee “intends to reduce [its] securities holdings over time in a predictable manner primarily by adjusting the amounts reinvested of principal payments received from securities held in SOMA.” The “predictable” bit is dovish, at the margins, as is the apparent suggestion that active selling isn’t likely right out of the gate.

On the MBS discussion, the Fed said that “in the longer run, the Committee intends to hold primarily Treasury securities in the SOMA, thereby minimizing the effect of Federal Reserve holdings on the allocation of credit across sectors of the economy.” That’s no surprise.

The same statement communicated the usual flexibility, something that’s usually taken as dovish by market participants, although it could also be hawkish, in theory. “The Committee is prepared to adjust any of the details of its approach to reducing the size of the balance sheet in light of economic and financial developments,” the final bullet point said.

The language around rates in the policy statement was tweaked Wednesday. “It will soon be appropriate to raise the target range for the federal funds rate,” the new statement said. The labor market was described as “strong.” In December, by contrast, the FOMC acknowledged the persistence of the inflation overshoot, but kept language which indicated officials weren’t yet prepared to declare mission accomplished on maximum employment.

Since then, the rhetoric has shifted. It’s clear the Fed won’t wait for the participation rate to rise to its pre-pandemic demographic trend before hiking rates, for example. Powell editorialized around that point at the December press conference.

Markets have aggressively repriced the Fed. March is fully priced (and then some), and traders see four hikes total in 2022, with risks skewed to the upside. Stocks would like to hear some pushback, even if “pushback” in this context just means officials haven’t already come to the conclusion that four hikes is the minimum given inflation realities.

It’s now extraordinarily unlikely that price pressures will abate materially in the near-term. The persistence of hot wage growth and elevated expectations risk embedding inflation in the economy. The Fed now recognizes the risk, but it’s far from clear they have the tools to control the situation at this stage.

But they have to try. Politics demands it. Speaking earlier Wednesday, Joe Biden said “we have to get prices in check for working people.”

The January statement described inflation as “well above” 2%. In December, the Committee said only that it had “exceeded 2%.”