MNI STATE OF PLAY: Fed To Pick Up Tightening Pace (RPT)

(Repeats story first published on May 3)

The Federal Reserve on Wednesday is expected to raise benchmark interest rates by 50 basis points in its most aggressive move in two decades to curb inflation. It's also set to announce plans to shrink its USD9 trillion balance sheet at a rapid pace starting next month.

The U.S. central bank, criticized for waiting too long to respond to soaring inflation, appears to be aiming to frontload multiple 50-bp increases to get the fed funds rate to around 2% before reassessing the pace of further rate hikes.

Investors will be looking for Fed Chair Jerome Powell to confirm those plans, or even to signal the FOMC is open to a still larger 75 bp move in June, as well as insight into the committee's latest thinking on how restrictive policy needs to get to combat inflation.

The Fed's blueprint for asset runoffs is likely to show a short ramp-up period leading to a combined USD95 billion monthly cap on the reinvestment of proceeds from maturing Treasuries and agency mortgage-backed securities.

STRONG MOMENTUM

Fed officials are hoping to bring demand and supply back into balance amid a very tight labor market, and as the war in Ukraine and Covid lockdowns in China continue to snag supply chains. A stagflationary scenario raises the likelihood of the Fed's having to take rates above 2.5%.

American consumers are likely to be able to withstand the rate increases without too much pain, giving officials confidence, while businesses report concern over when supply-related price pressures will ease.

But softening economic growth and higher unemployment later this year could shock the Fed into slowing or pausing its string of rate hikes, former officials cautioned.

LAUNCHING QT

Expectations for tighter monetary policy are already filtering through to financial conditions. Mortgage rates climbed at their fastest rate since the early 1980s so far this year.

On top of a historic rate move Wednesday, the Fed is expected to present a more aggressive plan to shed its holdings of Treasuries and MBS. Powell said in the effect of QT this year is similar to an additional quarter-point rate hike.

At the proposed USD95 billion a month cap, it would take three to four years to shrink the balance sheet to roughly 20% of GDP, according to a Richmond Fed analysis. During that time, the proportion of the Fed's portfolio that is MBS will have risen a couple percentage points because Treasuries run off significantly faster.

That prompted officials in March to discuss eventually selling some mortgage bonds on the open market so as to make progress toward holding a portfolio that's primarily Treasuries.