How the Fed’s Balance Sheet Can Deal With Inflation

The Federal Reserve is focused on containing high inflation, but it will take more than higher borrowing costs to curb price increases.

The central bank will also need to find a strategy with what to do with its nearly $ 9 trillion in assets, a strategy that could prove critical to the effectiveness of the Fed’s attack on rising prices.

In question: a sudden tightening of the Fed could disrupt the bond market, risking a recession.

“Interest rate hikes are the news yesterday,” Morgan Stanley chief executive Jim Caron told Yahoo Finance on Tuesday. Caron said the “main push” of the Fed’s policy will come from how it reverses the stimulus from its balance sheet.

Since the start of the pandemic, the Fed has collected trillions of dollars in U.S. Treasuries, which has depressed longer-term borrowing costs (as part of the Fed’s efforts to stimulate demand). Longer-dated US Treasury bonds (like 10-year or 30-year bonds) have remained weak during the pandemic and the recovery that followed.

With prices rising nearly 7% year-on-year, the Fed is now trying to end that program – a process it hopes to complete by March. Next, the Fed will consider raising short-term interest rates and discussing ways in which it can actually reduce its assets.

“We are aware that the balance sheet is $ 9 trillion. It’s way above what it needs to be, ”Powell told Congress in testimony Tuesday.

The question: how should the Fed anticipate interest rate hikes with any balance sheet? Does it matter?

The yield curve

Powell was silent on the thinking of the Fed. But other Fed policymakers have voiced concerns about rising interest rates in a “flat” yield curve.

Because US Treasury yields serve as a sort of proxy for interest rates, a 2-year Treasury at 0.89% roughly implies that the Fed could raise interest rates by about 0.75% ( or three interest rate hikes of 0.25% each) in relation to its pandemic context. close to zero.

But the Fed is now signaling that it could get much more aggressive than that over the next few years.

The 10-year US Treasury (^ TNX) rose alongside expectations of a Fed tightening. But on Tuesday afternoon, the 10-year was hovering around 1.75%, meaning markets may not believe the Fed can credibly raise interest rates seven or eight times before yields run out. term do not swing higher than long term returns.

A “reversal” of this type has historically served as an indicator of recession.

The balance sheet comes into play as the unwinding of asset holdings could have the effect of increasing returns in the longer term, according to St. Louis Fed Chairman Jim Bullard. He told reporters on January 6 that he would expect a reduction in the size of the balance sheet to put “upward pressure” on long-term interest rates.

“It would be a smoother process if we made the interest rate increases in tandem with a reduction in the size of the balance sheet,” Bullard said.

Kansas City Fed Chairman Esther George also said the Fed needs to be on the lookout for long bond rates.

“I think it will be appropriate to intervene earlier in the balance sheet compared to the last round of tightening,” he added. noted in a speech Tuesday.

Jim Caron of Morgan Stanley said the balance sheet is what will make the Fed’s rate hikes impactful, not the other way around.

“People who call for more aggressive Fed rate hikes miss him. What they need to think about: The Fed needs to raise rates to an optimal level, but they also need to use the tightening balance sheet to tighten financial conditions. “

The Fed’s next policy decision is slated for January 26.

Brian Cheung is a reporter covering the Fed, Economics and Banking for Yahoo Finance. You can follow him on Twitter @bcheungz.

Follow Yahoo Finance on Twitter, Facebook, Instagram, Flipboard, LinkedIn, Youtube, and reddit

Comments are closed.