Despite being two years into the pandemic, the U.S. economy has demonstrated remarkable resilience with the assistance of unprecedented fiscal and monetary policy support. Multiple rounds of fiscal stimulus aggregating to several trillion dollars, coupled with the Federal Reserve reducing their policy rate by 150 basis points and doubling the size of their balance sheet through quantitative easing, undoubtedly prevented a much more severe economic outcome. The result, however, was a highly stimulated economy and the Fed now faced with battling consumer inflation readings not seen in nearly 40 years.
While the recovery has been impressive, it has also been uneven given the COVID variant waves, supply chain disruptions, and policy uncertainty in Washington. Yet, with the unemployment rate back below 4% and year-over-year consumer price inflation at 7%, early notions of ‘transitory’ inflationary pressures have shifted to concerns about more persistent inflation becoming embedded in investors’ outlooks.
As the market has grappled with what this means for the level of interest rates and the evolving shape of the yield curve, short-term interest rates have moved sharply higher from their pandemic lows. While the shape of the yield curve steepened significantly in early 2021, this trend reversed course over the balance of the year. The move higher in short-term interest rates contributed to significant flattening of the curve throughout the fourth quarter of 2021.
Notably, the fourth quarter of 2021 witnessed a sharp policy pivot on the part of the Federal Open Market Committee (FOMC) that became rapidly focused on tightening policy to control inflation. This ensuing process of policy tightening which includes ending asset purchases, increasing the federal funds rate, and reducing the size of their balance sheet is widely expected to occur to varying degrees throughout 2022 and beyond. While Federal Reserve officials have been prepping the markets for several months for this eventuality, the sense of urgency seems to be growing.
A look back at the most recent cycle can provide some useful perspective. The last time the FOMC was faced with unwinding accommodative policy that involved all three of these elements, the process unfolded slowly over several years. For example, the asset purchase program to expand the balance sheet was wound down over the course of 2014, while the first increase in the federal funds rate did not occur until December 2015. Another full year went by before the FOMC raised their policy rate a second time in December 2016. Two additional interest rate increases occurred before the Committee began the process of balance sheet reduction in late 2017, which concluded later in 2019. In reducing the size of their balance sheet, the FOMC slowed the reinvestment of maturing securities with the amounts capped on a monthly basis for both Treasuries and agency mortgage-backed securities (MBS). These caps were gradually increased to a monthly run rate deemed appropriate by the Committee to bring the size of the balance sheet in line with that required to achieve their policy objectives.
Fast forward to 2022 and, while the FOMC strives to be as transparent as possible through various communication mechanisms, many questions remain regarding the eventual path of this tightening cycle. With the FOMC now expected to conclude balance sheet expansion (asset purchases) and begin raising short-term interest rates in March, investors continue to debate the timing, pace, and magnitude for both interest rate increases, as well as the balance sheet run-off process.
The FOMC’s recently concluded January policy meeting yielded some clues yet left many questions unanswered. The Committee indicated that changes in the federal funds rate would be the primary tool utilized for adjusting policy and expects the process of balance sheet reduction to begin after interest rate increases are underway. The FOMC indicated their holdings of Treasury and agency MBS will be reduced “in a predictable manner primarily by adjusting the amounts reinvested of principal payments received from securities held in the System Open Market Account.” As such, it currently does not appear the Committee is of the mind to reduce their securities holdings with asset sales. The remaining questions surrounding the timing, frequency, and magnitude of interest rate increases will be answered with policy adjustments driven by the evolution of observed trends in the economic data.
With all this information in hand, the front end of the yield curve already reflects the likelihood of at least three increases in the federal funds rate in 2022. Yet, despite the elevated levels of inflation, the yield curve has continued to flatten so far this year, indicating investor confidence in the Fed’s willingness and ability to control inflation.
A multitude of factors will influence the success of this policy transition, however, orchestrating a soft landing that brings inflation back to their policy target while not negatively impacting the growth outlook is a tall order given the current circumstances. As such, it is reasonable to expect financial markets to reflect heightened volatility this year as investors navigate the current economic recovery that not only continues to be impacted by the pandemic, but now, by declining levels of monetary policy accommodation as well.
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.
Executive Vice President, Senior Portfolio Manager
Boyd Watterson Asset Management, LLC