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Wednesday 12 January 2022
Decoding - For the Fed, the "next big thing" will be the reduction of the balance sheet
The minutes of the December FOMC clearly show that the Fed will soon initiate a policy of balance sheet reduction in 2022. Several reasons are pushing it to this and it will have significant market repercussions.
What the December 2021 FOMC minutes show
At the December FOMC, the Fed decided to accelerate its “tapering”, that is to say to reduce its net purchases of securities (Treasury securities and MBS) a little more than expected, with an end to the net purchases that would take place in mid-March 2022. The next question about the Fed's balance sheet was whether the balance sheet size would remain stable for some time or whether it would be reduced (quantitative tightening). While Jerome Powell had indicated that debates were underway on the subject, the minutes of the December FOMC indicate that the reduction of the balance sheet should actually happen quite quickly in 2022: it is mentioned there dozens of times!
Among the points raised on the subject in the minutes:
- The reduction of the balance sheet should start shortly after the first rate hike,
- The reduction of the balance sheet could be faster than in 2017/2018/2019,
- The reduction of the balance sheet would be done as last time, by setting monthly non-reinvestment caps,
- The size of the balance sheet is much higher than at the end of QE3, in absolute level and as a% of GDP and FOMC members mentioned that the Fed was better positioned for a reduction of the balance sheet than in 2017,
- “Some participants” consider that a significant reduction in the balance sheet could be appropriate, in particular given the abundant liquidity on the money markets and the significant use of reverse repo operations,
- “Some participants” see the reduction of the balance sheet as a way to avoid the flattening of the curve during the cycle of rate hikes,
- “Some participants” would prefer that non-reinvestments focus more on MBS than on Treasury securities.
Moreover, a consensus seems to be emerging in the FOMC that the "maximum level of employment" could be reached "soon" if the ongoing momentum continues on the labor market: this opens the door to a rate hike in March. Another striking point: a quasi-consensus emerges on the fact that the rate hikes could intervene faster and stronger than expected if necessary: this opens the door to a rate hike of 50 bps at a given time, even if it remains unlikely at the moment...
Download full document below.
Bastien Drut, Chief Thematic Macro Strategist at CPR AM