The Federal Reserve began plans to begin cutting bonds it holds at its December meeting, with members saying a balance sheet reduction is likely to begin sometime after the central bank starts raising interest rates, it said on Wednesday published protocol.
While officials have not made a decision on when the Fed will begin winding down the nearly $8.3 trillion in Treasuries and mortgage-backed securities it holds, statements from the meeting suggested the process would begin in 2022 could, possibly in the next few months.
“Virtually all participants agreed that it would probably make sense to begin a balance sheet rundown sometime after the first hike in the policy rate target corridor,” read the summary of the meeting.
Market expectations are currently for the Fed to start raising interest rates in March, which would mean that the balance sheet rundown could begin before the summer.
The minutes also noted that once the process began, “the appropriate pace of balance sheet reduction would likely be faster than during the previous normalization episode” in October 2017.
The size of the Fed’s balance sheet is significant as the central bank’s bond purchases were seen as a key element in keeping interest rates low and strengthening financial markets by keeping money flowing.
Wall Street reacted negatively to the news, with stocks falling and Treasury yields rising on the prospect of a more hawkish Fed in 2022.
Fed officials repeatedly said during the meeting that they believe the ultra-loose policy introduced in the early days of the Covid-19 pandemic is no longer warranted or warranted. Committee members expressed concern about rising inflation and said they see the labor market close to full employment.
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“They talked about more than that. Obviously there was quite a long discussion. This was quite a serious conversation,” said Kathy Jones, chief fixed income strategist at Charles Schwab, of the transcript, which had a special section titled “Discussion on policy normalization considerations.”
“The fact that almost all participants agreed that it was appropriate to initiate balance sheet repair after the first increase in the target range for the fed funds rate implies that there is not much of an appetite for ‘let’s wait,'” Jones added added. “Last time they waited two years. This time it looks like they’re ready to go.”
During this 2017-2019 taper, the Fed allowed a limited level of proceeds from the bonds it held to roll off each month while it reinvested the rest. The central bank started by rolling off $10 billion worth of Treasuries and mortgage-backed securities each quarter, and increased by that amount each period until the caps reached $50 billion.
The program was intended to significantly reduce the balance sheet but was short-circuited by global economic weakness in 2019 followed by the pandemic crisis in 2020. Overall, the cut amounts to only about $600 billion. Former President Donald Trump has been a vocal critic of the program, which is sometimes referred to as “quantitative tightening,” as he berated Fed officials.
Rate hikes, rejuvenate ahead
As expected, the Fed’s Policy Making Group left its reference rate anchored near zero after the December meeting. But officials also said they foresee an increase of up to three-quarters of a percentage point in 2022, as well as another three increases in 2023 and two more the year after.
Officials at the meeting noted that inflation readings “had been higher and more resilient than previously expected,” the minutes said. While members said growth will be “robust” in 2022, they also said inflation is a strong risk, perhaps even more so than the pandemic.
Consequently, they said it was time to tighten policy sooner than expected.
“Some participants judged that less accommodative future policies would probably be warranted and that the Committee should express a strong commitment to address heightened inflationary pressures,” the minutes read.
With that in mind, the committee announced that it would accelerate the pace of tapering its monthly bond-buying program. Under the new plan, the program would now end around March, after which the committee would free it to start raising rates.
According to the CME’s FedWatch Tool, the current pricing of the fed fund futures market indicates a 2:1 chance that the first rate hike will occur in March. Traders anticipate the next rise would come in June or July, followed by a third move in November or December.
Fed officials said the rationale for the moves was in response to inflation being higher and more persistent than they had anticipated. Consumer prices are rising at their fastest rate in almost 40 years.