Jerome Powell’s reluctance to lean more heavily on shrinking the Federal Reserve’s balance sheet in the battle against inflation could prove a damaging miscue.
A vocal section of the bond market prefers the Fed chair to focus more on reducing bond holdings, allowing policy makers to hike interest rates less aggressively as it battles to bring down 40-year high inflation. That would soften some of the pain of higher borrowing costs — a pertinent concern given the risks posed to the economy from the effects of Russia’s Ukraine invasion.
Advocates cite a number of potential advantages from putting greater emphasis on so-called quantitative tightening, rather than letting it simply run in the “background” as Powell says. A prime advantage, they say: it may help forestall an inverted yield curve, or prevent a particularly deep inversion.
Inverted yield curves, w. two-year yields exceed 10-year ones, precede recessions, and raise the risk of harming credit provision by lenders relying on short-term borrowing. When the Fed boosts its overnight policy rate, that tends to have a bigger impact on shorter-dated yields, flattening the curve. The gap in yields is now little more than a quarter point.
Even a flat yield curve is worrisome, with minutes from the Fed’s December policy meeting revealing concern this could pose financial-stability risks to lenders.
“More focus on the balance sheet reduction and less emphasis on rate hikes will create a steeper curve — which is good for financial companies across the board,” said Peter Tchir, head of macro strategy at Academy Securities.
The Fed has plenty of bond-portfolio runoff potential: its assets have swelled to $8.9 trillion after it launched a massive quantitative easing push in March 2020. The Fed now holds over $5.7 trillion of Treasuries and $2.7 trillion in agency mortgage-backed securities. It’s wrapped up its asset purchases this month.
Powell underscored in congressional testimony last week that the federal funds rate, currently near zero, is “our primary means of adjusting the stance of monetary policy,” while QT would be “running in the background and shrinking in a predictable way.”
Given the Powell Fed’s record of recalibrating its stance — including the accelerated shift in recent months toward halting bond purchases — a vocal minority of market participants is hopeful of a rethink, in time.
Powell said at a March 3 congressional hearing that the Fed will, at its March 15-16 meeting, set the pace for shrinking its bond portfolio. He said in a separate hearing a day earlier that the timeline for implementing a plan hadn’t been decided yet.
While Powell has declined to offer an estimate for any tradeoff between rate hikes and QT, he has acknowledged to lawmakers that t. are such estimates. Advocates of putting greater weight on QT say reducing the need for hoisting the policy rate as high as it would otherwise go would temper the hit to borrowers — something that’s especially important given the run-up in debt during the pandemic.
“I look at the sheer amount of leverage in the system” in assessing the risks of Fed policy, said Anne Walsh, chief investment officer for fixed income at Guggenheim Partners. “We could have an extremely significant and immediate increase in the cost of borrowing hit the system” depending on how much the Fed hikes, she said.
Futures pricing shows over six quarter-point rate hikes by the Fed during 2022, bringing the benchmark to above a 1.5% to 1.7% range.
Rapidly rising rates will test borrowers. U.S. corporate bonds outstanding have climbed by over $1 trillion since the end of 2019, as has American household debt. The federal government also borrowed heavily to fund pandemic aid, driving marketable debt outstanding up to almost $23 trillion.
Debt has been particularly cheap to service thanks to the Fed’s near-zero rate policy, with corporate-bond and Treasury yields having reached record lows during this period.
Another advantage with QT compared with rate hikes is the Fed has greater flexibility to be targeted, by adjusting how it scales down its holdings of mortgage-backed securities versus Treasuries, Tchir said.
Home prices have soared to record highs during the pandemic, fueled in part by record-low loan rates. One gauge of home values jumped almost 19% in the 12 months to December.
The Fed could in theory help to cool the market by disposing of its mortgage securities. “Many” officials considered that sales of those bonds “may be appropriate at some point” given the Fed’s agreement to hold mainly Treasuries over the longer term, minutes of the January policy meeting showed.
“The Fed will start with a passive runoff” of its bond holdings, said Gregory Faranello, head of U.S. rates trading and strategy for AmeriVet Securities. “But then they have to use the big bat that they have — which is putting duration into the marketplace and driving these longer-term rates higher. The market needs to be prepared for that — it almost seems inevitable.”