For an FOMC meeting resulting in no rate change, this meeting certainly offered market participants a clear insight into the Fed’s thinking. The headline from the FOMC statement and Powell’s remarks is that the Fed has left the 2024 Fed Fund dot plot at three quarter point eases for the remainder of the year and expressed their belief and hope that recent increases in inflation data are merely a bump in the road toward their 2% inflation goal, not the beginning of a new direction higher for inflation. There’s more to unpack here which I’ll do in a moment, but what was also important in the press conference were the Fed Chair’s remarks about QT, which I believe are more significant than most people in the market realize.
But first, rates.
The big takeaway from Chairman Powell’s remarks was that the Fed’s view of the last two months of inflation prints, which had come in on the higher side, were “just a bump in the road.” Powell led the discussion with standard comments such as “inflation has eased substantially but [is] still too high” and that “long-term inflation expectations remain well anchored.” But then he gave further insight into the Fed’s thinking, adding that “there could be some seasonal effects in the recent inflation data” which could explain the recent higher prints. These comments support their conclusion to remain biased to ease 3 times in 2024.
Sounds straightforward? Well maybe not quite. If you ask yourself, where does this truly leave the Fed, I’d say in a position where the next few inflation data prints matter a tremendous amount! Powell effectively confirmed this when he commented, “[the Fed] is looking for data to confirm the low inflation data of last year”. My interpretation of this comment is that the Fed is okay with a couple of months of higher prints but probably not more than three or four. The next two prints are set for March 29 (PCE) and April 10 (CPI). I think the market will be watching these closer than ever as will the Fed. Bad prints could lead to no eases in 2024 at all. So, let’s just stay tuned.
And now, the Fed’s comments on QT.
How quickly and when will the Fed end its QT program have always been the key questions when it comes to QT. The Fed’s official statement said that they have left the pace of QT unchanged, meaning they will continue to look to shrink their balance sheet by roughly $75 billion / month. But then in the press conference, Chairman Powell added that he believes that the Fed will taper QT “fairly soon.” This “Fed Speak” can mean the Fed will begin the tapering process for QT anywhere from its next meeting to possibly even late in the summer.
The significance of this statement and the corresponding timing of this process is that the Fed wants to “avoid the turbulence” that we saw in 2019. Powell even said they don’t want to end up “short reserves,” which is what we saw in September of that year. The Fed is obviously acutely aware that they need to have ample reserves in the system. Our call is as follows:
We think that while the Fed may begin to taper QT this summer, it’s not until after the RRP facility goes to zero and the Fed’s balance sheet shrinks enough to decrease bank reserves from $3.5T to somewhere in the $2.8T-$2.6T range that they will end QT entirely.
The bottom line is this. The taper process is coming, but later than many expect and for longer than they expect. In addition, the Fed getting this process right is extremely important, as we saw in 2019. The taper process and the ending of QT will determine (1) the ultimate level of bank reserves in the system; (2) whether the Fed has accurately judged if there are ample reserves in the system and (3) what kind of funding environment there will be in terms of the difficulty and the cost of funding positions, which is of course highly relevant to fixed income relative value investors.
This much we know for sure: the uncertainty around when this occurs and what level reserves ultimately fall to, will drive volatility in the funding markets.