Fed favors reducing monthly asset runoff pace by roughly half

Bonds

Federal Reserve policymakers “generally favored” slowing the pace at which they’re shrinking the central bank’s asset portfolio by roughly half, minutes from their latest gathering showed.

The record of the March 19-20 Federal Open Market Committee meeting also showed “almost all” officials judged it would be appropriate to begin lowering borrowing costs “at some point” this year. However, inflation data since then has upended expectations for three interest-rate cuts this year.

The Marriner S. Eccles Federal Reserve building in Washington on Feb. 19, 2021.

Bloomberg News

Policymakers “noted that the disinflation process was continuing along a path that was generally expected to be somewhat uneven,” according to the meeting minutes released Wednesday.

Fed officials began discussing plans for slowing down the process of unwinding their massive balance sheet, known as quantitative tightening, though no decisions were made at the meeting.

Although most officials saw the process as proceeding smoothly, they “broadly assessed” it would be appropriate to take a cautious approach to further runoff given market turmoil in 2019, the last time the Fed tried to shrink its portfolio.

“The vast majority of participants thus judged it would be prudent to begin slowing the pace of runoff fairly soon,” the minutes showed.

The Fed has been winding down its holdings of Treasuries and mortgage-backed securities — a process known as quantitative tightening, or QT — at a rate of as much as $95 billion per month. Fed Chair Jerome Powell said at his press conference on March 20 the Fed is considering slowing the pace fairly soon to “help ensure a smooth transition, reducing the possibility that money markets experience stress.”

Officials generally favored keeping the existing cap on mortgage-backed securities, but adjusting the cap on Treasuries, the minutes showed.

Wall Street is homing in on what level of bank reserves is appropriate to guarantee liquidity and avert past blowups in financial markets. The amount of cash institutions have parked at the Fed stands at nearly $3.5 trillion. That’s a level policymakers characterize as abundant, and they’re aiming for ample, which Powell defined at last month’s post-meeting press conference as “a little bit less” than that.

A few policymakers indicated they preferred to continue the balance-sheet runoff at its current pace until market indicators begin to show signs reserves are nearing that ample level. 

For now, short-term funding markets have been stable and stress free, which offers considerable flexibility as officials consider the path ahead for QT. If the Fed lets reserves shrink too much it risks triggering volatility in overnight funding markets similar to what was seen in September 2019. However, too many reserves consume bank capital and inhibit lending, and ensure the Fed bank maintains a large footprint in the Treasury cash and repo markets. 

During the last QT cycle that began in 2018, the central bank was letting as much as $30 billion in Treasuries and as much as $20 billion in agency-backed mortgage debt run off before it decided to start slowing that pace the following year. But by the time the Fed did so, market pressures were already evident. 

The combination of increased government borrowing and a corporate tax payment created a shortage of reserves in September 2019, driving a five-fold surge in a key lending rate and a spike in the federal funds rate above the target range. The Fed was forced to intervene and buy Treasury bills to increase the amount of reserves. 

The minutes also underscored officials’ reluctance to lower rates until they have more evidence inflation is firmly on a path to 2%, the rate they see as the sweet spot in a healthy economy.

March data on consumer prices released earlier Wednesday showed that January and February figures were more than a blip: A key measure of inflation exceeded economists’ expectations for the third straight month, posting a 0.4% rise from February and 3.8% from a year earlier.

While a narrow majority of policymakers had penciled in at least three rate cuts for 2024 when they met in March, the latest data weaken the case for reductions as soon as June and point toward fewer cuts in 2024.

Nine of 19 Fed officials indicated last month they expect no more than two cuts. Atlanta Fed President Raphael Bostic — who votes on policy decisions this year and expects just one reduction in the fourth quarter — and Minneapolis’ Neel Kashkari have floated the possibility of no rate cuts at all this year if inflation data continue to disappoint.

Ahead of the minutes, investors saw a chance of fewer than two reductions in 2024 and are expecting the first move won’t come until September at the earliest, according to futures markets.

Policymakers voted unanimously to leave interest rates unchanged in a range of 5.25% to 5.5% last month and said in their post-meeting policy statement that they would hold them there until officials gained “greater confidence” that inflation was moving toward 2% in a sustainable way.

Powell said in remarks at Stanford University on April 3 that officials have time to let data guide policy given the strength of the economy and progress on inflation so far. US employers have added 829,000 jobs in the first three months of the year, as strong consumer demand continues to bolster economic activity.

In quarterly economic projections released last month, Fed officials ramped up their estimates for 2024 growth, to 2.1% from 1.4% in December. Their outlook for core inflation also ticked higher to 2.6% by the end of the year.

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