Brace for a March Fed lift-off

Fed View: Rate hike in March; balance sheet runoff soon after

Following further unexpectedly strong labour market data last Friday, and a number of Fed speakers (Barkin and Bostic) since showing openness to a March interest rate rise, we have brought forward our expectation for the start of rate hikes from June previously. Following a 25bp hike in March, we continue to expect the Fed to hike at a quarterly pace until it reaches the pre-pandemic target range of 1.50-1.75%, but this is now expected to be reached one quarter sooner – in Q2 2023. As such, we now expect four hikes in 2022, up from three previously, while we continue to expect three hikes in 2023. From mid-2023, we expect the Fed to hike at a slower, semi-annual pace, while it seeks to gauge the impact of existing rate rises. We continue to expect the fed funds rate to peak at 2.5-2.75% in 2025, but there is naturally uncertainty surrounding a forecast this far out.

Labour market is tightening rapidly

The main reason for our view change in rates is the rapid tightening we have seen in the labour market in recent months. The unemployment rate saw another sharp fall in December, to 3.9% from 4.2%, which followed a similarly sharp fall in November (from 4.6%). This has come despite a modest improvement in labour force participation, which dampens falls in the unemployment rate. Unemployment is now already below the level consistent with the FOMC’s view of full employment (4%) – something we did not expect to happen until late Q1 previously. Hourly earnings are also growing rapidly, at 5.8% annualised as of the latest 3m/3m reading. Such a rapid pace of wage growth is likely to keep upward pressure on inflation, and although we still expect inflation to come down significantly in the course of this year, we expect core inflation to settle above the Fed’s 2% target at c.2.5-3%. The risks to this forecast continue to be to the upside, and in turn, the risk is that the Fed has to do even more to contain inflation than is currently in our base case.

Balance sheet wind-down to start in late Q2

With the December FOMC minutes last week providing confirmation that the Fed is likely to take a more aggressive approach to winding down its balance sheet, we now expect this to begin soon after the March lift-off, perhaps as soon as May. According to the minutes, Committee members think the current environment of high inflation and a tight labour market, in combination with a significantly bigger balance sheet as a starting point, calls for a more rapid unwind of the balance sheet than during the 2017-18 ‘quantitative tightening’ (QT) episode. Last time, maturing Treasuries and MBS were allowed to roll-off the balance sheet, i.e. proceeds from redemptions were not reinvested, in amounts up to $50bn per month at the peak. Initially, we expect this new round of QT to start at a slow pace of $15bn per month, with the pace doubling each month until it reaches a $60bn per month pace (this amount includes both Treasuries and MBS; the Treasury portion being c.$40bn). However, our analysis of the Fed’s holdings – which are more skewed to the short-end of the yield curve this time around – suggest a theoretical maximum pace of around $100bn per month, and we do not rule out the Fed allowing the balance sheet to unwind at this pace. Even allowing the balance sheet to wind down at $100bn per month, at end 2023 the balance sheet would still be well over $2tn bigger than it was before the start of the pandemic.

What about the risk of funding market stress?

Last time around, the Fed had to prematurely end its unwind of the balance sheet, and even started buying shorter dated securities again in order to satisfy financial institution demand for cash vs bonds. This demand for cash became structurally higher following the financial crisis amid stricter regulations requiring larger cash buffers. In the 2017-18 QT episode, the Fed underestimated that demand for cash, and there is a risk that this happens again. However, with the Fed’s balance sheet having essentially doubled during the pandemic, it is likely much further away from the level that would cause funding market stress. Moreover, the Fed now has a permanent standing repo facility as an additional liquidity buffer, which likely allows for a smaller balance sheet over the longer run. As such, we do not view the risk of funding market stress as an impediment to a more rapid balance sheet unwind.

Policy outlook depends significantly on financial conditions

There is significant uncertainty surrounding our Fed view, not only from the macro side, but also from financial conditions. On the macro side, our base case for the Fed is conditioned on a significant fall in inflation, albeit to still above-target levels. Should inflation fail to fall back significantly, the Fed may have to step on the brakes even harder than we currently expect – perhaps, for instance, by raising rates at each FOMC meeting. With regards financial conditions, the risks run both ways. So far, bond and equity markets have been remarkably calm in response to the hawkish pivot by the Fed. Should bond yields begin spiking sharply, and/or equity markets correct in a disorderly manner, the Fed might slow down the pace of tightening, as such market moves would do some of the tightening work for it (however, we think the bar for such a ‘Fed put’ is much higher than in the past; see Question 3 in our Global Outlook). On the other hand, should bond yields fail to rise in line with our forecast, this may indicate to the Fed that it needs to do more to ensure tight policy is adequately transmitted through markets and the economy. (Bill Diviney)