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With inflation still well above the US Federal Reserve’s target and the unemployment rate now below estimates for the long-term maximum level, the Fed reiterated its recent guidance following its January: Officials expect to raise the policy rate in March, launching a series of four rate hikes in 2022. Although the Fed’s short-term rate path points to a faster and faster hike in response to inflationary risks, we have not changed our expectation that a still-low neutral rate, larger central bank balance sheet and generally higher economy-wide debt levels will maintain the terminal level of this rate hike cycle at or even below that reached in 2018 (i.e. a range of 2.25% to 2.5%).

Meanwhile, Fed officials signaled an earlier start to central bank balance sheet liquidation (a process known as quantitative tightening, or QT) by issuing a list of balance sheet policy principles, which provided high-level information on the Fed’s plan for a significant reduction in assets held. While officials did not provide additional details on the likely pace or start of the program, we expect it to begin around mid-year (after asset purchases end in early March), when the federal funds rate should be above 0.5%.

Schedule Acceleration

Since the previous FOMC (Federal Open Market Committee) meeting in mid-December, a surprisingly strong jobs report in December prompted Fed officials to once again push back expectations of takeoff from the current rate. federal funds from 0% to 0.25%. The unemployment rate of 3.9% is now below FOMC estimates for its long-term level (a proxy for maximum employment), and inflation is well above the Fed’s long-term target (2 % PCE, or personal consumption expenditure). Although headline inflation levels are expected to moderate this year, the strong labor market recovery and resulting wage pressures were likely the main factors behind the Fed’s plan to remove the accommodating policy. We believe the Fed is aiming for a more neutral stance to position policy against high inflation risks.

To that end, the Fed used the January meeting – the last meeting before the scheduled take-off in March – to formally signal an upcoming rate hike by amending the forward guidance section of the January FOMC statement to say that it will “soon” be appropriate to raise rates. . March’s rate hike should kick off a streak of quarterly rate hikes and the start of QT later this year, given Fed Chairman Jerome Powell’s comment at the March conference. press that it will soon be appropriate to “step away” from the current very high rate. accommodative monetary policy.

50 basis point hike – bridge too far?

While Chairman Powell reiterated the FOMC’s expectations for a streak of rate hikes, he refrained from suggesting that a 50 basis point rate hike is likely in March (although he doesn’t). also not ruled out). Although Chairman Powell has confirmed that the committee believes it has reached the necessary labor market and inflation benchmarks to begin the rate hike cycle, inflation is expected to moderate further in the coming quarters, which will reduce probably the need for a sharp adjustment at the March meeting.

Nevertheless, Chairman Powell reiterated that the FOMC will be fully aware of the risk that inflation to treat increases – which tends to happen when wage increases lead to larger price increases, which lead to further wage increases, and so on. Although headline wage pressures have accelerated as labor markets tighten, the balance of evidence still suggests that the currently high level of headline inflation will moderate as pandemic-related frictions in labor markets labor and products will fade over time.

Balance sheet outlook: faster start, faster decline

As expected, the Fed announced the end of its asset purchase programs in early March, while also signaling its intention to start reducing its balance sheet soon by publishing the list of principles mentioned above. Minutes from the December FOMC meeting suggested that assets held would likely begin to decline earlier and at a faster pace this cycle compared to the previous cycle, although Chairman Powell said further discussions on the Details of any program will be discussed at future meetings. Nevertheless, despite the more aggressive approach, the Fed also reiterated its preference for passive reduction, rather than outright selling in the secondary market.

Based on these forecasts, we expect the Fed to announce the passive reduction of its balance sheet by ceasing to reinvest proceeds from maturing US Treasuries and agency mortgage-backed securities (MBS). . We also expect the Fed to set higher caps on Treasury coupons and MBS reinvestment compared to the last cycle, which would target a faster decline in the balance sheet over the next few years. Indeed, we estimate this would allow the Fed to shrink the size of its balance sheet by more than $1 trillion by the end of 2023 – a much faster rate of decline than was achieved in the cycle. 2017-2018. Still, with the size of the balance sheet currently about $4 trillion larger than pre-pandemic levels, the Fed will still have a long way to go before achieving full normalization.

Visit The PIMCO inflation page for more information on the inflation outlook and investment implications, and visit our interest rates page for our latest views on the rate environment.

Tiffany Wilding and Allison Boxer are economists and regular contributors to the PIMCO-Blog.

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