The Fed’s U-turn kicks into high gear

The Fed’s U-turn kicks into high gear

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Douglas Cote

Douglas Coté, CFA

Head of Global Perspectives Strategies

The erstwhile, extraordinary bull market advanced on a tailwind of low, short-term interest rates and massive Federal Reserve purchases of longer-maturity debt securities intended to stabilize long-term rates, referred to as “quantitative easing.” Last week, the Federal Open Market Committee had the world’s attention as it raised the Fed funds rate by 75 basis points, to 1.75%. Less noticed was that on June 1, the Fed began the process of reducing its $8.5 trillion balance sheet. The Fed plans to withdraw significant amounts of money from the debt markets — to do the exact opposite of quantitative easing, or “quantitative tightening” if you will ― a policy U-turn.

This doesn’t mean, however, that the Fed will start selling securities; balance sheet reduction will occur “primarily by adjusting the amounts reinvested of principal payments received from securities held in the System Open Market Account (SOMA).[1]” Withdrawals started on June 1 with $47 billion of principal payments not reinvested: $30 billion from U.S. Treasury securities plus $17.5 billion from agency mortgage-backed securities. After three months, this redirection of principal payments will increase to $95 billion per month: $60 billion of Treasuries and $35 billion of mortgage-backs, respectively, being taken out of the system to reduce the Fed’s balance sheet.

In my view, this is a Volcker-style inflation-buster, named after Paul Volcker, the Fed chairman who, back in the early 1980s, raised rates to astronomical levels, sent the United States into recession and broke the high inflation that had plagued the 1970s. There are many other, less damaging ways to break the current bout of inflation without triggering a recession, on which I would be happy to advise, should Fed Chair Powell call me. In the meantime, it may be prudent to brace for an impending storm.

 
[1] Source: Plans for Reducing the Size of the Federal Reserve's Balance Sheet, May 4, 2022; https://www.federalreserve.gov/newsevents/pressreleases/monetary20220504b.htm

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