The balance sheet is “substantially larger than it needs to be,” and “there is a substantial amount of shrinkage to be done.” We’ll put some numbers to it.
By Wolf Richter for WOLF STREET.
In reaction to the FOMC announcements and Powell’s post-meeting press conference today, the 10-year yield spiked nearly 10 basis points, to 1.87%, the highest since December 2019, and the two-year yield spiked by 15 basis points to 1.17%, the highest since mid-February 2020.
Stocks sagged from their bounce before the meeting. The Dow dropped about 600 points between 2 p.m. and the close, and the S&P 500 dropped 73 points, from being up about 1.5% to being down 0.15%. Futures are now down about 1% for the Dow and the S&P 500, and about 1.5% for the Nasdaq. Stocks in Asia are spiraling lower.
Markets had expected that Powell would soothe their rattled nerves, as he’d done before, and perhaps walk back some of the recent hawkishness, at least in tone, but that didn’t happen. The opposite happened.
Powell explained that “monetary policy will become significantly less accommodative,” that the Fed would “move over time to a policy that is not accommodative,” and that high inflation readings would have important implications for the path of the rate hikes.
“A significant threat to the labor market is high inflation,” he said. A long recovery, such as the last recovery which was the longest on record, requires low inflation, he said, thereby turning over the argument that the Fed couldn’t tighten because it would threaten the labor market.
The Fed has a lot of room to raise interest rates without damaging the labor market, he said.
This Fed loathes to surprise the markets.
Long-gone are the days of surprise rate hikes. The speeches of the Fed governors, Powell’s statements and post-meeting press conferences, and the statements and minutes from the FOMC prepare the markets for what is coming so that they can gradually adjust to it, over time, and not all at once, on one day – which could cause seizures in the financial markets.
Powell today explicitly praised the success of the Fed’s jawboning, that it had worked very well, because markets had already priced in multiple rate hikes for 2022. And today was a further effort at preparing markets for what is coming.
The FOMC announced today in its statement that it would end QE entirely in “early March,” and that it would start hiking interest rates “soon.” And after the rate hikes begin, the Fed would “significantly” reduce the size of its balance sheet.
In the post-meeting press conference, Powell then added more precision about the timing of the initial rate hike and the beginning of the balance sheet reduction.
Rate hike on March 16.
“The Committee is of the mind to raise the federal funds rate at the March meeting,” he said. That means March 16 for liftoff.
And the balance sheet reduction would begin “sometime later this year, perhaps, we haven’t made a decision yet,” he said.
When asked, Powell refused to rule out interest rate hikes at every meeting this year. He also refused to rule out hikes of 50 basis points.
By way of answer, he reiterated – as he’d already done several times during the presser to make sure everyone got it – that the Fed would remain “nimble” in this economy that was running hotter than anything seen many years, with inflation far above the Fed’s target, and with a “very, very, very strong labor market,” and a “historically tight” labor market, as he put it.
The balance sheet reduction looms large.
In a separate statement, the Fed announced plans “for significantly reducing” its balance sheet, and that in the longer run, it intends to shed its holdings of mortgage-backed securities (MBS) entirely. The Committee members voted unanimously for this plan.
The balance sheet reduction would take place “in a predictable manner,” the statement said.
Powell added that the runoff, once on track, would take place systematically “in the background,” in the foreground being the rate hikes.
When Powell was asked what “significantly reducing” the balance sheet means, he said that the balance sheet was “substantially larger than it needs to be,” and that “there is a substantial amount of shrinkage to be done,” but that the Fed wants that shrinkage to be “orderly and predictable.”
He said that the balance sheet was of “shorter duration” (holding more bonds with shorter maturities) than last time when the Fed reduced its balance sheet (2018 through mid-2019), and that the economy is much stronger, inflation much higher, and the labor market much tighter than it was back then, he said.
The balance sheet reduction would “move sooner and also perhaps faster” than last time, he said. Last time, after a phase-in period, the balance sheet reduction was capped at $50 billion a month.
How fast? Over $100 billion per month. But the Fed will cap it.
The Fed would reduce its balance sheet “primarily” by allowing maturing bonds to run off the balance sheet without replacement, according to the statement today. This runoff could be big if the Fed doesn’t cap it.
The runoff associated with the Fed’s $5.69 trillion in Treasury securities. To pick a time frame: In August, September, and October combined, $197 billion in short-term Treasury bills and $198 billion in Treasury notes and bonds will mature, for a total of $395 billion. If the Fed just lets them mature without replacement, the balance sheet would be reduced per month on average by $131 billion, just from the Treasury runoff.
Even if the Fed decided to keep its Treasury bills on the balance sheet, the runoff of the T-notes and T-bonds alone would amount to an average of $66 billion per month over the period.
The runoff associated with the Fed’s $2.67 trillion in MBS. MBS are different from regular bonds, and this is key: Holders of MBS, such as the Fed, receive passthrough principal payments when mortgages are paid off, such as when a house is sold or refinanced, and when mortgages are paid down with regular mortgage payments.
In 2021, the Fed received over $60 billion in passthrough principal payments per month. To increase its MBS holdings by $40 billion a month, the Fed in effect ended up purchasing between $100 billion and $110 billion a month in MBS.
This stream of passthrough principal payments will slow as rising mortgage rate typically cause refis to decline. But there will still be a lot of refis, and a lot of payoffs when homes are sold, plus the constant stream of principal payments from regular mortgage payments.
These passthrough principal payments are unpredictable, but given the huge size of the Fed’s MBS holdings would continue to be very large and could very well amount to $30-60 billion per month.
In other words, if the Fed doesn’t cap the runoff of Treasury securities and MBS, it could amount to over $100 billion per month, or a balance sheet reduction of over $1.2 trillion during the first year.
This is why the Fed will likely cap the runoff, and as Powell indicated probably at an amount higher than last time, when the cap was $50 billion per month. But back then, the cap wasn’t hit in every month because in some months, less than $50 billion in securities matured.
According to Powell, the Fed will decide these details, such as the cap, over the next few meetings. Once that is decided and the runoff kicks off, it will proceed “in the background.”
I will then, of course, pull this runoff from the background into the foremost foreground on about a monthly basis, to see how it is progressing – as I did last time.
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