Key Takeaway: Fed is waking up from its 2021 inflation slumber.
Key Question: Will Fed over-react with a combined interest rate hike and balance sheet reduction to damage economy in 2023?
Key FOMC minutes stat: “Balance sheet” was mentioned 28 times, a surprise focus for a narcoleptic central bank.
The FOMC minutes jolted the US interest rate markets from their holiday hangovers with a robust discussion over when, where and how much to reduce its bloated balance sheet. Here are some of my favorite quotes:
Participants noted that the current weighted average maturity of the Federal Reserve’s Treasury holdings was shorter than at the beginning of the previous normalization episode. Some observed that, as a result, depending on the size of any caps put on the pace of runoff, the balance sheet could potentially shrink faster than last time if the Committee followed its previous approach in phasing out the reinvestment of maturing Treasury securities and principal payments on agency MBS.
Some participants judged that a significant amount of balance sheet shrinkage could be appropriate over the normalization process, especially in light of abundant liquidity in money markets and elevated usage of the ON RRP facility.
They noted that current conditions included a stronger economic outlook, higher inflation, and a larger balance sheet and thus could warrant a potentially faster pace of policy rate normalization.
Many participants judged that the appropriate pace of balance sheet runoff would likely be faster than it was during the previous normalization episode.
To achieve such a composition, some participants favored reinvesting principal from agency MBS into Treasury securities relatively soon or letting agency MBS run off the balance sheet faster than Treasury securities.
The repeated language of rapid reduction of balance sheet simultaneously with interest rate increases explains the rapid rise in US 10yr bond yields and the sharp sell-off in equities that occurred after the minutes were released.
Perhaps the most disturbing text was this:
Participants remarked that inflation readings had been higher and were more persistent and widespread than previously anticipated.
How was the Federal Reserve surprised by this? The answer is they weren’t. They choose to ignore it while they pursued an “inclusive” employment objective over their inflation mandate. Last year in April, we wrote warning of inflation that would surge due to the Biden administration’s infrastructure spending (BIF) and the Fed’s sanguine approach to monetary policy. Chickens-home-roost.
The risk now is what the risk is always with central banks. They lag when inflation rises and then they rush to catch-up, making a mess of the economy and raising unemployment. The kicker will be timing. Monetary policy tightening works with a lag (12-18 months?). As the Fed begins the process, the economy will slow as the extraordinary fiscal spending spree ends and consumer spending drops.
The final takeaway is this: Any time a central bank makes a political decision on monetary policy instead of an economic decision, bad things start to happen. Expect more interest rate and equity volatility in 2022 as this plays out and negatively impacts growth in 2023.