The Fed's potential policy tightening combination has never been seen before to trigger unease about markets and the economy

The Fed's quick combination of rate hikes and balance sheet cuts will unsettle bond and stock markets that have already been hit.

Combining these two layers of monetary policy tightening, and rapidly rolling them out, is an unprecedented approach for the Fed, while the impact on markets and the economy remains unknown. Investors are voicing concerns about the outlook. Over the past 10 trading days, the Nasdaq Composite has fallen more than 8 percent, while U.S. Treasuries have fallen about 1.8 percent this month.

"The scale they're thinking about now is completely unprecedented," said Janice Eberly, a former Treasury department official who now works at Northwestern University. "It is prudent to gauge market reaction, especially before adjusting the balance sheet in conjunction with rate hikes."

Fed Chairman Jerome Powell and his colleagues would like to see the financial situation tighten somewhat to moderate the strong economy slightly and help reduce the Qualcomm (174.17, -4.69, -2.62 percent) bloat that has only been seen in decades. Following last year's record stock market and house prices, a pullback in asset prices will help the process, as long as the decline does not ultimately hurt economic stability.

What makes this task even trickier is that the Fed has only shrunk its bond inventory once between 2017 and 2019, so there aren't many references to try to calculate the impact of this larger, faster quantitative tightening.

John Williams, president of the Federal Reserve Bank of New York, expects long-term interest rates to "rise" as the central bank shrinks its balance sheet. But he acknowledged last week that the magnitude of the impact of such quantitative austerity is "highly uncertain." "We have to be humble," he told the Foreign Relations Association on Friday.

relief valve

William Dudley, one of John Williams' predecessors, thinks the process will go well. Stable communication planned by the Fed will help, as will the liquidity support implemented by the central bank last year. The so-called standing repo facility provides banks with a simple way to exchange U.S. Treasuries for cash, a safety valve that helps avoid seeing another liquidity crunch in 2019.

However, Matthew Luzzetti, chief U.S. economist at Deutsche Bank, said investors believe the balance sheet is a much larger "tightening force" compared to some of the Fed's analysis, which will raise the risk of a surprise sell-off of risk assets.

Equity investors are becoming increasingly cautious as traders increasingly expect that the Fed will begin to shrink its bond portfolio in the months following the launch of the March rate hike.

Back in 2017, the Fed only began to normalize its balance sheet nearly two years after raising short-term policy rates from near zero. And the Fed was then taking steps to reduce its bond inventory, starting at $10 billion a month and slowly but steadily increasing to $50 billion a year later.

Policymakers, including Powell, have made it clear that this time they will pick up the pace.

Monetary policy experts say a different approach makes sense: The economy is stronger than it was last time it was reduced, inflation is much higher and its balance sheet is much larger. What's more, the Fed holds $326 billion in Treasury bills, which could disappear from the balance sheet in a matter of months if they are not reinvested.

While some corrections in risky assets may help the Fed, a sharp decline could hurt the recovery. To avoid that, policymakers may communicate central bank intentions with investors, in Powell's words, by preparing the public for what it intends to do.

They may have a way to make that happen.

On Jan. 13, Morgan Stanley chief U.S. economist Ellen Zentner told reporters after a meeting of the American Bankers Association's Economic Advisory Committee that the committee generally agreed that the balance sheet reduction would begin in the middle of the year. But opinions vary as to how fast the process is advanced.

For her part, Zentner expects to announce an initial monthly reduction in balance sheet size of $40 billion in July and rapidly increase to $80 billion in September. In addition to this, she also expects to see the Fed raise rates four times this year, 25 basis points each.

Quantitative tightening

Complicating the outlook even more: Some policymakers describe quantitative tightening as a potential alternative to a rate hike by a certain margin, just as quantitative easing could replace a rate cut.

Brian Sack, head of global economics at Deshao Fund Group, estimates that the balance sheet will need to be reduced by about $600 billion before it is close to the equivalent of a 25 basis point rate hike. By comparison, a 2018 paper he and Joseph Gagnon wrote for the Peterson Institute for International Economics estimated it at $300 billion.

This change is due to the Fed releasing more quantitative easing during the pandemic, and long-term yields are lower and less volatile than in the past. Sack also cites evidence that "interest rates are very resilient to changes in the supply of government bonds."

"The economy is strong enough that the Fed may have to raise the federal funds rate substantially, even though it is also shrinking its balance sheet," added Sack, a former Fed official.

Barclays Chief U.S. Economist Michael Gapen highlighted the sheer amount of cash stored in the Fed's reverse repurchase tool, about $1.6 trillion, as evidence that the Fed could easily push for more aggressive quantitative tightening.

This article originated from the financial world