Fed Talks Quantitative Tightening
by Craig Dismuke, Dudley Carter
The Fed’s December meeting minutes revealed in-depth discussions about the future path of policy, including the Fed’s plans for its balance sheet. The minutes showed general agreement on certain high-level aspects of the eventual normalization process but unsettled opinions about key details. There was widespread agreement that balance sheet runoff would occur closer to lift-off of the Fed funds rate relative to the last cycle. In the aftermath of the Financial Crisis, portfolio holdings were first reduced 22 months after the first rate hike and four hikes into the tightening cycle. Many also expect the pace of run-off to “likely be faster than it was during the previous normalization episode.” In justifying a faster normalization process, participants identified several differences between today’s environment and that of the last cycle: a “much stronger” economic outlook, “higher inflation”, “a tighter labor market”, and a “much larger” balance sheet. Officials appeared less settled on the ultimate size of the balance sheet and the composition of holdings, although a portfolio of primarily Treasuries is considered to be the consensus favorite.
The Fed’s balance sheet has more-than doubled since February 2020, up $4.6 trillion to $8.76 trillion. They are still adding new holdings at a rate of $90 billion per month ($60b Treasury and $30b MBS), down from a rate of $120 billion per month in November. They are expected to continue tapering the rate of monthly purchases through March when new purchases are expected to be completed. Procedurally, this timeline would open the door to a rate hike beginning in March. Given the expectations for a faster pace of normalization, the door would then open for quantitative tightening shortly thereafter.
For context, the Fed reduced its portfolio holdings from September 2017 to July 2019 by $689 billion to $3.76 trillion. This quantitative tightening process was discontinued in July 2019, six weeks before the first of two back-to-back rate cuts.