When COVID-19 hit the U.S. in early 2020, there was enormous uncertainty regarding the outlook for the path of the virus and its economic consequences. Policy makers reacted quickly by dusting off playbooks developed during the Financial Crisis, and then went way beyond that, injecting an unprecedented degree of stimulus into the economy. The much earlier-than-expected rollout of vaccines, combined with the massive tailwinds from policy stimulus, helped jolt the economy into an unexpectedly sharp V-shaped recovery.
Stimulus, though, appeared to have been calibrated on the assumption it would be a slow climb-back for the economy, as happened after the GFC from which it took years to recover. As the economy started to reopen, the massive policy response helped unleash a torrent of household purchasing power and aggregate demand that ran up against more persistent COVID-supply disruptions and a lagging recovery in the available workforce. Inflation quickly emerged as the pressure valve.
The Fed spent much of last year catching up to the reality of a stronger growth and higher inflation environment. But shortly before and during its December 2021 meeting, the Fed pivoted sharply and since then, has only added to its new-found sense of urgency to unwind some of its monetary stimulus. With the unemployment rate dipping to 3.9% in December 2021 and inflation accelerating to a 40-year high of 7%, Fed officials are clearly nervous about the projected path of inflation. Notably, all FOMC participants shifted in December 2021 to the view that rate lift off would be appropriate this year, with a median projection of three rate hikes as a base case. As expected, the Fed also doubled the pace of tapering, with QE purchases now scheduled to end by mid-March 2022.
But in yet an additional twist to its tightening, the Fed is also apparently speeding up plans to launch Quantitative Tightening (QT)—that is, a program to cease at least some of the principal reinvestments of Treasuries and MBS now in its SOMA portfolio, allowing the size of the portfolio to shrink over time (Figure 1).1
Figure 1
The Fed's SOMA Portfolio: An Illustrative Runoff
PGIM Fixed Income and Haver Analytics. Note: Assumes QT begins in September 2022 and ramps up to a maximum pace of $75 billion/month by January 2023.
Fed Chair Powell indicated at his December press conference the Fed is likely to continue its QT discussions over the next several meetings, but Fed officials have signaled a QT launch is likely sometime later this year—much sooner after its first rate hike than the two-year interval during its last tightening cycle. The Fed is acknowledging a lot that is different compared to the last time—the economy is in better shape, inflation is high, and the balance sheet surge is much larger. All of this suggests the Fed is also likely to follow a faster pace of QT this time compared to its period of QT in 2017-2019.
At this point, we also have moved up our base case timing for both rate hikes and QT. The Fed now appears poised to lift the Fed funds rate by 25 bps at its March meeting—if not, then at its May meeting instead, followed by two additional rate hikes this year, in our view. The market at this point is almost fully priced for lift off in March and for four full hikes over the course of this year. We still expect Fed rate hikes will likely fall somewhat short of market pricing this year, although we think there is two-way risks around our base case of three rate hikes. If inflation remains stubbornly high and a price/wage spiral continues to pose a risk, Fed tightening could well wind up being more aggressive than we now expect. But given our projection that economic growth and inflation are likely to soften somewhat on their own over the course of this year, the Fed may ultimately find it prudent to slow down its pace of tightening later this year, particularly if it is also launching an early start to QT.
QT Mechanics—Likely Similar to the Last Go-Round, But Earlier and a Bit Faster
Last time around, the Fed announced a QT plan that consisted of a series of gradually rising caps/limits on the amount of MBS and Treasury securities allowed to roll off each month. In October 2017, they began a process of reinvesting only those amounts that exceeded preset caps initially set at $6 billion/month for Treasuries and $4 billion/month for MBS. Those monthly caps gradually increased every three months in increments of $6 billion and $4 billion, respectively, until total caps of $30 billion/month and $20 billion/month were reached. But a year and a half later, the Fed was forced to make a U-turn, cutting the cap for the amount of Treasury rolloff in half, and ceasing QT altogether at the end of July 2019. MBS rolloff continued, but those proceeds were henceforth reinvested into Treasuries, consistent with the Fed’s longer-run goal of reverting back to a Treasury-only SOMA portfolio.
It is very possible the Fed could use the same QT process this time around, although it would likely implement larger baseline caps and ramp up more rapidly to what is expected to be higher maximum caps on run-off than previously. There are several differences this time that would suggest a faster and more aggressive QT. This time, the balance sheet expanded more rapidly to a much larger size–although, as before, the Fed doesn’t need to shrink the balance sheet in order to hike rates effectively. But the Fed probably wants to avoid getting to the point where the huge size of the balance sheet becomes a political issue, and they likely don’t want to see the balance sheet ratchet ever higher each cycle as a share of GDP.
Moreover, the Fed has more tools to help manage QT this time around. The Fed has a reverse repo facility that has effectively been mopping up excess reserves and which reached a peak of almost 2 trillion in December 2021. The high usage of this facility has been providing an indication of the degree of excess reserves in the system (Figure 2).
Figure 2
Usage of the Fed's Reverse Repo Facility
Federal Reserve Board and Haver Analytics.
In addition—and importantly—the Fed also now has a standing repo facility to offer up additional liquidity to the system in the event the Fed mistakenly over-does QT this time around. The problem the Fed faces is that it doesn’t know how strong demand for reserves in the banking system actually is. They find out by trial and error and seem to have overdone it in 2019 when they had to reverse course and engineer a U-turn. But the repo and reverse repo facilities now provide a more automatic means for either mopping up or providing additional liquidity as needed.
QT: The End Game
We suspect that, just as in the 2017-2019 QT period, the Fed may well stop short of fully unwinding its QE purchases of the last two years. Although precise projections are difficult—particularly as details around the Fed’s plans for QT are yet to come—the Fed could perhaps be done with its QT after about two years or so. Similar to last time, the notion that QT will have a finite life is a factor that markets undoubtedly will factor in. While the potential for a more rapid timeline for implementing QT has surprised us (we had thought a 2023 start was more likely), a QT start later this year may come at an opportune time, given the U.S. Treasury’s planned cutbacks in coupon issuance this year.
But given the likelihood that QT will be occurring alongside Fed rate hikes, the combined tightening may appear sufficient earlier in this cycle as well. If aggregate demand conditions moderate this year as we expect, and supply disruptions improve, inflation and GDP growth may be naturally moderating by the second half of 2022. With the torrid pace of re-openings behind us, no significant additional fiscal boost on the horizon, and current high inflation rates eating into household purchasing power, we expect inflation will likely have moderated by the end of this year. If so, this should ease pressure on the Fed to ramp up its planned tightening campaign further and sow the seeds for the Fed funds rate to reach a cycle peak of perhaps 1.5% -2.0% and for QT to end, as well.
1SOMA refers to System Open Market Account, which includes securities acquired through the Fed’s QE programs.