The Fed minutes for the March meeting indicate that the Fed balance sheet reduction is likely to progress sooner than expected. Whilst no concrete plan had been finalised, the minutes note that the process could begin "as early as after the conclusion of its upcoming meeting in May." The market consensus was that quantitative tightening would only start in July. The minutes also state that it "expects to begin reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities at a coming meeting" (https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20220316.pdf).
The Fed is acting to stem rampant inflation. To this end, Fed Governor Lael Brainard, traditionally a dove, said on Tuesday that "it is of paramount importance to get inflation down" and that the Fed will start "to reduce the balance sheet at a rapid pace as soon as our May meeting" (www.cnbc.com). According to the minutes, the tightening will be capped at $60bn/month for Treasuries and $35bn/month for agency MBS, phased in over three months (or longer if warranted by market conditions). Admittedly, this is considerably higher than the combined starting cap of $10bn/ month in 2017, but then again, the balance sheet size makes it a different beast altogether.
The Fed is currently holding approximately $3tn in MBS. Given rising rates, there is an inherent extension risk, impacting the Fed's reduction plans. Moreover, this exacerbates because prices of bonds typically come down as rates increase, meaning the Fed is likely to sell its longer-term holdings at a loss. Thus, there is pressure on the Fed as it attempts to run off its balance sheet. In addition to the stagflationary obstacle, this complication makes tighter monetary policy tricky to implement. However, given that the housing industry is almost 20% of the US economy, this process is another headwind that the Fed must manage as it looks to tighten aggressively.
Senior Market Specialist
Russell Shor joined FXCM in October 2017 as a Senior Market Specialist. He is a certified FMVA® and has an Honours Degree in Economics from the University of South Africa. Russell is a full member of the Society of Technical Analysts in the United Kingdom. With over 20 years of financial markets experience, his analysis is of a high standard and quality.