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Date : May 17, 2022

Fed Moves Aggressively to Curb Inflation

Minutes of the Federal Reserve Board’s March meeting, released Thursday, show policy makers “generally agreed” to reduce the central bank’s $9 trillion balance sheet at a rate of $95 billion a month – an aggressive move to stem the upward creep of inflation threatening U.S. economic growth.

The cuts will be $60 billion in Treasury securities and $35 billion in mortgage-backed bonds.

“Participants also generally agreed that caps could be phased in over a period of three months or modestly longer if market conditions warranted,” the minutes said.

The amounts would be considerably more than the Fed reduced its holdings during the 2017 to 2019 period, when it cut back at the rate of $50 billion a month.

Markets had anticipated the Fed would detail its plans to further pull back on the extraordinarily accomodative monetary policy it has followed since the coronavirus struck in March 2020. At its mid-March meeting, the Fed voted to cut interest rates by 25 basis points, although the minutes reveal some had argued for a larger cut.

The Dow Jones Industrial Average was down more than 300 points following the news.

The release of the minutes was preempted somewhat when two Fed officials, including vice chair nominee Lael Brainard, gave speeches in which they said the central bank was primed to be more aggressive in its fight against inflation.

Brainard said the Fed was ready to begin reducing the amount of securities it holds on its balance sheet as early as next month.

“It is of paramount importance to get inflation down,” said Brainard, currently a Fed governor, during a webinar. She added that the Fed’s balance sheet could “shrink more rapidly” than it did beginning in 2017 when the central bank sold off its assets at a $50-billion-a-month rate.

San Francisco Fed Bank President Mary Daly also spoke, saying it was necessary to raise interest rates “to ensure that again, [you] go to bed at night, you’re not worrying about whether prices will be higher, considerably higher tomorrow.”

Both women are considered “doves” among the Fed, meaning they have traditionally supported accommodative monetary policy.

But with unemployment at 3.6%, 11 million open job positions and companies having to raise wages to attract workers, the Fed is facing a difficult fight in its battle against consumer inflation, now running at an 8% annual rate.

Although markets have bid up yields on bonds for weeks now, the twin comments sent shock waves through bond trading rooms. The yield on the 10-year Treasury traded above 2.6% before settling a little lower Tuesday.

Adding to the carnage, the average rate on a fixed, 30-year mortgage loan broke the 5% barrier Tuesday, while the Dow Jones Industrial Average fell 281 points.

The moves set up a summer where the Fed will be trying to engineer a “soft landing” amid prices that are rising at a pace not seen since 1982. More and more economists are now raising the possibility of a recession, if not this year then in 2023.

Deutsche Bank on Tuesday became the first major bank to predict a recession, putting good odds on it occurring late next year.

“We no longer see the Fed achieving a soft landing. Instead, we anticipate that a more aggressive tightening of monetary policy will push the economy into a recession,” Deutsche Bank economists led by Matthew Luzzetti wrote in the report.

Investors and economists have become obsessed with an inversion among bond yields, where shorter-term bonds pay a higher percentage than longer-term ones. That is a signal that markets are more worried about an upcoming economic downturn.

While that is a reliable indicator of recessions, it is not as precise a timing measure, as inversions can occur as long as a year or more before a recession actually begins.

Markets were down between 4% and 8% in the first quarter, recovering in March from a much deeper drop earlier in the year but not enough to turn positive.

“Much of the poor performance in the first quarter came from the prospect of higher interest rates, and this was incorporated into prices,” Brad McMillan, chief investment officer for Commonwealth Financial Network, wrote on Tuesday. “With markets expecting multiple hikes, that is already priced in – and markets can now react to better economic and earnings news.”

“Similarly, uncertainty about the Ukraine war spiked in March, but many of the worst possibilities failed to materialize, leaving the potential for upside ahead,” he added. “The big picture is that the first quarter had several risks priced in, such as COVID-19, inflation, and continued supply chain issues. For the next quarter, those risks are now part of the picture, rather than a shock. And with a solid baseline for markets, companies are proving they can operate and make money under these conditions.”

Robert Frick, corporate economist at Navy Federal Credit Union, says consumers may say they are concerned about inflation and have less confidence in the economy, but they continue to spend.

“Spending on goods is still far above trend,” he says, but a shift is underway back toward spending on services as the economy reopens and more people are vaccinated, or boosted, against the coronavirus.

“There has been a big shift to spending and employment in services,” Frick adds. “Consumers have a lot of money, household debt is really low. On the flip side, confidence has dropped.”

Ultimately, what the consumer does will decide the fate of the U.S. economy in the near term. With jobs plentiful and wages rising, there is hope consumers will be resilient to external shocks as they have been for some time. But as costs for basic necessities like food, energy and shelter continue to increase at double-digit rates, that optimism will be tested by an aggressive Fed.