January 18, 2022

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Fed Will Pivot Toward Balance Sheet to Protect the Yield Curve

(Bloomberg) — The most important comments Federal Reserve Chairman Jerome Powell made during Tuesday’s testimony before the Senate’s banking committee revolved around his view of the central bank as still adding stimulus to the economy. Powell said point blank that the Fed needs to quickly draw this accommodation to a close. But how?

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Judging from his statements, it looks like a large balance sheet reduction will be a critical tool for the Fed as it navigates a receding pandemic-era economic environment. A balance sheet pivot gives the central bank more tools to reduce accommodation without inverting the yield curve.

Powell gave a number of reasons as to why the balance sheet is likely to play a more critical role going forward. First, the Fed wants flexibility given the unprecedented nature of the pandemic. Optionality is key due to increased uncertainty — and the balance sheet gives the Fed more of it.

Powell also spoke at length about the Fed’s inability to address supply-side problems with demand-side solutions — like interest rate hikes — while answering questions from Republican Senator Pat Toomey of Pennsylvania. That too suggests that the balance sheet is at play.

And Powell said the balance sheet today is much bigger than it was four or five years ago, when the Fed last attempted to shrink it. That means any moves now are likely to be much larger than they were then. He also said that the Fed’s balance sheet composition would allow it to roll off faster due to the duration of assets.

Finally, Powell also spoke about the balancing act the Fed had to play between on the one hand allowing the expansion to last longer in order to increase labor force participation, and on the other hand, the need to slow inflation, which acts as a regressive tax on American households. The Fed can’t navigate that process with one blunt instrument. And so, Powell made clear that the bank is now in the process of trying to achieve consensus around a multi-pronged approach.

Overall, Powell sounded hawkish to me. His comments about the Fed still adding stimulus even suggested he thinks the Fed is behind the curve. That means we should expect the Fed to tighten aggressively in 2022. And his recognition of over-reliance on interest rates as the only tool means the Fed is likely to shrink the balance sheet aggressively this year as well. Given the room the Fed has on duration spreads before the yield curve inverts, I would expect the Fed to lean on the balance sheet should the curve flatten aggressively in order to keep the expansion running.

This was a post on Bloomberg’s Markets Live blog. The observations are those of the blogger and not intended as investment advice. For more markets analysis, go to MLIV.

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https://finance.yahoo.com/news/fed-pivot-toward-balance-sheet-181009013.html