Policymakers at the U.S. Federal Reserve not only decided to pause interest rate increases at their meeting in late January but also to stop shrinking the Fed balance sheet later this year because it was rattling markets.
Minutes of the January meeting released Wednesday, revealed that members of the Federal Open Market Committee (FOMC) had questions for staff about reports flooding the market that the balance sheet runoff, or quantitative tightening (QT), was unsettling investors. Respondents to the Fed survey of primary dealers and market participants placed little weight on balance sheet reduction as a factor affecting risk sentiment.
“However,” the minutes continued, “some other investors reportedly held firmly to the belief that the runoff of the Federal Reserve's securities holdings was a factor putting significant downward pressure on risky asset prices.” In thin, year-end trading, this may have had an “outsized effect” on market prices.
So the staff presented options for ending the asset reductions “at some point over the latter half of this year,” a proposal the policymakers readily seized upon.
“Almost all participants thought that it would be desirable to announce before too long a plan to stop reducing the Federal Reserve’s asset holdings later this year.”
Such an announcement would help put investors’ minds to rest, they felt.
Bank reserves, the liability counterpart for much of the bond portfolio, are probably a bit higher at $1.6 trillion than they need to be for efficient monetary policy, they observed, but the additional liquidity could forestall volatility in short-term interest rates.
In line with its declared intention to hold primarily Treasuries over the long term, participants thought it best to reinvest maturing mortgage-backed bonds into Treasuries, maintaining the overall level of the balance sheet but gradually reducing the MBS portion. Further details were to be discussed at later meetings, but the emphasis was on maintaining flexibility.
On the whole, the minutes showed that policymakers feel there is little harm in pausing rate increases, as downside risks to the economy now overshadow any worries about inflation. They reluctantly acknowledged that their historic framework of pre-emptively attacking inflation as employment improved doesn’t seem necessary, given that core inflation continues to run below their 2-percent target.
The inflation conundrum seemed to puzzle them. Measures of inflation compensation – the market premium on inflation risk – have moved lower. That may be due to inflation expectations running lower than the target, or it might just reflect the general decline in risk premiums or “increased concerns about downside risks to the outlook for inflation.” Who knows?
The outlook for inflation seems to belong in that category outlined by former U.S. Defence Secretary Donald Rumsfeld when he talked about things we know we don’t know. The FOMC seems to know it doesn’t know what’s going to happen with inflation.
The best they could do, according to the minutes, is to conclude “rate increases might prove necessary only if inflation outcomes were higher than their baseline outlook.” Still, “several other participants” held on to the hawkish notion that a rate hike will be on the table later this year, if the economy develops as they expect.
The overwhelming market expectation at this point is that there won’t be another rate hike this year, so the hopeful attitude of those hawks might give investors pause.
Several FOMC participants had “nudged down” their outlook for economic growth from December, and it seems that another thing they know they don’t know is what will happen with the economy. The projection materials accompanying the March meeting, which will include the aggregate forecasts compared to December’s, will be enlightening in this regard.
Likewise, the dot-plot graph of individual expectations of interest-rate levels, which should show a decided shift from the expectation of two or three rate hikes this year.
There was little market reaction to the minutes since Fed officials had largely telegraphed their intentions regarding quantitative tightening ahead of the release.