With the facts revealed at the first meeting of the year, the Fed signaled that a rate hike would be appropriate in the near future and that the balance sheet reduction would begin after the rate hike. While the central bank prioritizes the fight against inflation in the phase of withdrawing ultra-loose policies, it seems that it will apply the dynamic, fine-tuned model in relation to other economic variables, especially in balance sheet reduction. The phenomena of progress in the economy occur in a contradictory order, especially with the highest rate of 7% inflation seen since the 1980s, a labor market returning to its pre-pandemic level is in the middle, and a tightening aggressiveness that cannot interfere with the main focus of inflation narrows the comfort zone in the economy. In the monetary policy progress, the facts to be considered after this stage are as follows.
Highlights from the Fed statement;
· With inflation well above 2% and a strong labor market, the committee hopes it will soon be appropriate to raise the target range for the federal funds rate.
· The balance sheet reduction process will begin after the target range increase process for the federal funds rate begins.
· The sectors most adversely affected by the pandemic have recovered in recent months, but are affected by the recent sharp increase in COVID-19 cases.
· Risks to the economic outlook remain, including new variants of the virus.
· The FOMC removed the previous opening line from the Central bank's statement stating that it is "determined to use all its tools to support the US economy at this challenging time."
In March, the Fed will raise interest rates for the first time since 2018. Key market indicators are not at a level to show an extreme reaction in terms of interest rates with different maturities. However, after the March rate hike, it is very likely that it will go beyond the 3 rate hike zones projected for the rest of the year. The position in futures funds currently shows that by December 2022, 4 rate hikes will be completed during the year. In fact, there is no direct time reference for neutral interest rates, but at the stage when asset purchases are completed and balance sheet growth is completed, an interest rate increase is theoretically appropriate and it is clear that it would not be very beneficial for the Fed to turn the table in either direction at the moment. Holding back from tightening causes them to have difficulty in controlling inflation instability, and market instability can also trigger the risk phenomenon by worrying about monetary policy failure. Besides; A tightening wheel that ignores market and economic risks will also be an approach that underestimates risks in a fuzzy environment where risks to the economic outlook are evaluated.
Until September, there was no clear consensus on interest rates, but as the Fed did not cling to the "inflation temporary" rhetoric in recent months, the balance here quickly shifted to the point of tightening monetary policy. The Fed actually tends to move faster than the 2014 model taper tantrum phenomenon. Amid strong demand, battered supply chains and tightening labor markets, inflation is well above desirable levels. While the Fed is proactive in bringing this inflation band closer to its 2% target, it will also need to not harm the recovering labor market.
US inflation indicators… Source: Bloomberg
The Fed's balance sheet stands at about $8.9 trillion, more than double its size before officials began large asset purchases to defuse market panic at the start of the pandemic. After the rate hike, balance sheet regulation will begin. Alongside the FOMC statement, “balance sheet size reduction principles” were also published. If we look at the items here in general terms and elaborate;
· The Committee sees changes in the federal funds rate target range as the primary means of adjusting the monetary policy stance.
· The Committee will determine the timing and pace of reducing the size of the Federal Reserve's balance sheet to support maximum employment and price stability goals. The committee hopes that shrinking the size of the Federal Reserve's balance sheet will begin once the process of increasing the federal funds rate target range begins.
· The Committee aims to reduce the Fed's securities holdings in a predictable way over time, primarily by adjusting the reinvested amounts of principal payments received from securities held in the System Open Market Account (SOMA).
· Over time, the Committee aims to keep its securities in the amounts necessary to implement monetary policy efficiently and effectively in a plentiful reserve regime.
· Over the longer term, the Committee primarily aims to hold Treasury securities in SOMA, thereby minimizing the impact of Fed assets on credit allocation across sectors of the economy.
· The Committee is ready to change any detail of the balance sheet reduction approach in light of economic and financial developments.
It will show flexibility over time and its priority seems to be an ideal balance sheet transition in terms of predictable balance sheet reduction, at least as it does not prioritize direct sales whose upper limit is difficult to foresee and adjust at this stage. Consequently; It is understood that we will be at a minimal discount point in long-term bonds, while the redemption priority in reducing Treasury bonds is being addressed. A gradual and data-driven approach will be adopted, at least while increasing the upper limit of QT. On the MBS side, you can be more active.
The Fed is not in an action zone other than communication to reduce asset purchases. In his speech, Powell made clear his intention to raise interest rates in March. It is not at a point of discourse and action to be disturbed. The tapering model based on objective facts is being processed.
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