At the current rate of consumer price index inflation, the cost of living in the United States would double every nine years. So wrote Robert Phipps, a director at Per Stirling Capital Management, in a note released Friday.
Wary of such a potentially devastating impact on households, the Federal Open Market Committee signaled its seriousness about stemming inflation at its March meeting: to bolster its rate-tightening, the central bank will begin cutting back on its balance-sheet-engineered stimulus.
The Fed purchased more than $4 trillion (half its holdings) of Treasury bills and bonds and mortgage-backed securities issued by government-sponsored enterprises since the pandemic’s onset (see chart). In the process, it surpassed the balance sheets of the Bank of Japan and the European Central Bank.
Reversing this record-setting monetary intervention in financial markets will probably start in May. The Federal Open Market Committee informally agreed to lower its $8.9 trillion in holdings by a maximum of $60 billion in Treasuries and $35 billion in MBS each month. The securities won’t be sold but instead will be allowed to “roll-off” — holdings will decline as principal payments come in and less is reinvested.
However, FOMC members said they could consider outright sales of agency MBS once the balance sheet runoff gets underway. (They represent 32%, or $2.7 trillion, of the total portfolio.) In the past, some Fed presidents have indicated a preference for reducing MBS holdings first to minimize the effect of balance-sheet holdings on the allocation of credit across economic sectors.
The $95 billion monthly cap is larger than the pace set when the Fed tried a course of tapering from 2017 to 2019. During that period, the Fed managed to shrink the balance sheet to $3.8 trillion but then had to start buying again six months later when COVID-19 ripped through the United States.
But $95 billion a month isn’t a lot — at that pace it would take about 5 years to reduce the portfolio to its pre-pandemic size (to about 19% of GDP from the current 35%).
That’s by design. Tapering comes with many unknowns. “The process is still relatively novel,” admitted Lorie Logan, manager of the open market account for the FOMC, at a March 2 NYU Stern event. In fact, no central bank has ever been able to engage in sustained tapering.
There is one thing for certain. A significant reduction in asset holdings “will require meaningful adjustments to private-sector balance sheets, as investors absorb the net increase in Treasury and agency MBS issuance and money markets transition to lower levels of liquidity,” Logan said.
The FOMC stated it would be careful to adjust its approach to tapering as economic conditions warrant. That raises the question of how far into this five-year voyage the Fed will go before it has to stop or turn back.
Indeed, by perhaps waiting until what some economists think was too long to start to withdraw its stimulus, “the Fed … can no longer just tap on the brakes to dampen inflation,” Phipps said. “[It] will instead likely need to slam on the brakes, and that increases the likelihood of a recession.”