Blog

The Fed’s Road to Full Normalization

At the January 2022 meeting, the U.S. Federal Reserve signaled an accelerated timetable to normalize policy, but it will be a long process amid an uncertain environment.

With inflation still well above the U.S. Federal Reserve’s target and the unemployment rate now below estimates for the long-run maximum level, the Fed reiterated recent guidance following its January meeting: Officials expect to hike the policy rate in March, kicking off a series of four rate hikes in 2022. Although the Fed’s near-term rate trajectory indicates a sooner and more rapid rise in response to inflationary risks, we haven’t changed our expectation that a still-low neutral rate, larger central bank balance sheet, and generally higher economy-wide debt levels will keep the terminal level of this rate hiking cycle at or even below that achieved in 2018 (i.e., a range of 2.25%–2.5%).

Meanwhile, Fed officials signaled an earlier start to winding down the central bank’s balance sheet (a process known as quantitative tightening or QT) by releasing a list of balance sheet policy principles, which provided some high-level information about the Fed’s plan for a significant reduction in assets held. While officials didn’t provide additional details on the pace or likely start to the program, we expect it to begin around midyear (following the end of asset purchases in early March), when the fed funds rate is expected to be above 0.5%.

Accelerating the timetable

Since the previous FOMC (Federal Open Market Committee) meeting in mid-December, a surprisingly strong December employment report prompted Fed officials to once again pull forward expectations for liftoff from the current 0%–0.25% fed funds rate. The 3.9% unemployment rate is now below FOMC estimates for its long-run level (a proxy for maximum employment), and inflation has significantly overshot the Fed’s longer-term target (2% PCE, or personal consumption expenditures). Although headline inflation levels are expected to moderate this year, the strong labor market recovery and resulting pressures on wages were likely key factors behind the Fed’s plan to remove policy accommodation. We believe the Fed is targeting a more neutral stance in order to position policy for elevated inflation risks.

To this end, the Fed used the January meeting – the last meeting before expected liftoff in March – to formally signal an upcoming rate hike by amending the forward guidance section of the January FOMC statement to say it will “soon” be appropriate to raise rates. The March rate hike is likely to kick off a sequence of quarterly rate hikes and the beginning of QT later this year, given Fed Chair Jerome Powell’s comment at the press conference that it will soon be appropriate to “steadily move away” from the current highly accommodative monetary policy.

50 basis point hike – a bridge too far?

While Chair Powell reiterated FOMC expectations for a sequence of rate hikes, he stopped short of hinting that a 50 basis point rate hike is likely in March (although he didn’t rule it out, either). While Chair Powell confirmed that the committee believes it has achieved the labor market and inflation benchmarks needed to begin the rate hiking cycle, inflation is still expected to moderate over the coming quarters, likely reducing the need for an abrupt adjustment at the March meeting.

Nevertheless, Chair Powell reiterated that the FOMC will be quite attuned to the risk that the inflation process is moving higher – something that tends to happen when wage hikes lead to greater price hikes, which lead to further wage hikes, and so on. Although aggregate wage pressures have accelerated as labor markets tighten, the balance of evidence still suggests that the currently elevated level of headline inflation will moderate as pandemic-related frictions in labor and product markets moderate over time.

Balance sheet outlook: Sooner start, faster decline

As expected, the Fed announced an early-March end to its asset purchase programs, while further signaling its intent to begin to reduce its balance sheet soon by releasing the list of principles mentioned above. The December FOMC meeting minutes suggested that asset holdings would likely begin to decline sooner and at a faster pace this cycle relative to last cycle, although Chair Powell stated that additional discussions on the details of any program will be addressed at upcoming meetings. Nevertheless, despite the more aggressive approach, the Fed also reiterated its preference for a passive reduction, instead of outright sales in the secondary market.

Based on this guidance, we expect the Fed to announce the passive reduction in its balance sheet by ceasing its reinvestment of proceeds from maturing U.S. Treasuries and agency mortgage-backed securities (MBS). We also expect the Fed to set higher caps for Treasury coupon and MBS reinvestment relative to last cycle, which would target a faster balance sheet decline over the coming years. Indeed, we estimate this would allow the Fed to reduce the size of its balance sheet by over $1 trillion by the end of 2023 – a much faster pace of decline than what was achieved in the 2017–2018 cycle. Nevertheless, with the size of the balance sheet currently around $4 trillion higher than pre-pandemic levels, the Fed will still have a long way to go before it achieves a full normalization.

Visit PIMCO’s inflation page for further insights into the inflation outlook and investment implications, and visit our interest rates page for our latest views on the rates environment.

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

The Author

Tiffany Wilding

North American Economist

Allison Boxer

Economist

Related

Disclosures

All investments contain risk and may lose. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. References to Agency and non-agency mortgage-backed securities refer to mortgages issued in the United States. Diversification does not ensure against loss.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision. Outlook and strategies are subject to change without notice.

Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. There is no guarantee that results will be achieved.

PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2022, PIMCO.

PIMCO