The Federal Open Market Committee (FOMC) is likely to reduce its balance sheet "considerably more rapidly than in the previous recovery," according to Federal Reserve Governor Lael Brainard, in a speech made on April 5, 2022. "It is of paramount importance to get inflation down," she emphasized.
The size of the Fed's balance sheet was a record $8.9 trillion as of the week starting March 28, 2022. This is more than double the range of around $4.4 trillion that held from mid-2014 to early 2018, and it is also up sharply from a recent low of about $3.8 trillion in mid-2019.
During the "previous recovery" referenced by Brainard, which was in 2017-19, the Fed let its balance sheet shrink by about $50 billion per month. The markets are anticipating that the pace of reduction this time will be about twice that amount. Indeed, the minutes of the FOMC meeting on March 15-16, 2022, which were released a day after Brainard's speech, indicate that members generally favor setting the initial monthly rate of balance sheet reduction at about $95 billion.
- Fed Governor Lael Brainard indicated in a speech that the Fed is poised to reduce its balance sheet "rapidly" to control inflation.
- She expects balance sheet reduction to be much larger and faster than in 2017-19.
- The minutes of the March FOMC meeting, released a day later, reveal a growing consensus in favor of rapid balance sheet reduction.
- Market indicators point to expectations that the Fed will also raise interest rates sharply in 2022 and 2023.
Brainard's Key Points
To get inflation down, Brainard said that the FOMC will continue to tighten 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 its next meeting, on May 3-4. She expects much larger caps and a much shorter period to phase in the maximum caps compared to the 2017–19 period.
Brainard's discussion of caps indicates that the FOMC plans to reduce its balance sheet not by selling bonds but rather by not reinvesting some of the principal payments received when bonds mature. These caps are the limits that the FOMC will set on the amounts that will not be reinvested each month. She expects that the combined effect of interest rate increases and balance sheet reduction will bring the stance of monetary policy to a more "neutral" (i.e., less stimulative) position by late 2022.
Brainard noted that the full extent of additional monetary tightening over time will depend on how the outlook for inflation and employment evolves. Indeed, she notes that the U.S. economy has entered the current period of uncertainty (due in large part to Russia's war on Ukraine and its wide-ranging impacts) with "considerable momentum in demand and a strong labor market."
March FOMC Meeting Minutes
A day after Brainard's speech, on April 6, 2022, the FOMC released the minutes of its meeting held on March 15-16, 2022. All options presented by staff for balance sheet reduction envisioned a more rapid "runoff" than that experienced in 2017-19. Indeed, all participants agreed that elevated inflation and a tight labor market warrant starting balance sheet runoff at an upcoming meeting, with a faster pace of runoff than in 2017-19.
Participants generally agreed that monthly caps (i.e., maximum runoffs or reductions) of about $60 billion for Treasury securities and about $35 billion for agency mortgage-backed securities (MBS) would likely be appropriate. Participants also generally agreed that the caps could be phased in across three months or maybe slightly longer if market conditions warrant. Several participants indicated that they would be comfortable with relatively high monthly caps or no caps at all.
The markets are expecting interest rate increases at each of the FOMC's next six meetings in 2022, possibly adding up to a cumulative hike of 2.5 percentage points. Among those Fed officials who favor faster balance sheet reduction and rate hikes is Esther George, president of the Federal Reserve Bank of Kansas City. "I think 50 basis points is going to be an option that we'll have to consider, along with other things," she told Bloomberg TV on April 5.
On the morning of April 7, 2022, the CME FedWatch Tool was assigning a probability of 78.8% to a 50-basis-point rate hike at the May FOMC meeting and a 21.2% probability to a 25-basis-point increase. As of April 5, 2022, the Market Probability Tracker from the Federal Reserve Bank of Atlanta estimated that the market was anticipating a federal funds rate of about 2.64% by December 2022 and 3.15% by June 2023.
Both the CME FedWatch Tool and the Atlanta Fed Market Probability Tracker are based on complex analyses of securities whose pricing is driven by expectations about interest rates in general and FOMC policy moves in particular.