Statement 

The FOMC’s second meeting of the year yielded few surprises. The Committee raised the Fed Funds target range by one-half percent to between 0.75% and 1% and released its plan to reduce its bond holdings. Chairman Powell stated in his press conference that half-percent increases are under consideration at the upcoming June and July meetings. 
 
In its statement the Committee acknowledged additional supply chain pressures on inflation from China’s lockdowns and the Russian invasion. It views the economy as strong, with robust job gains, but recognized that activity had slowed slightly recently. 

Balance Sheet

The Fed’s bond portfolio of Treasury and mortgage securities more than doubled during the pandemic. Starting just above $4 trillion, the Fed’s bond buying pushed the portfolio to $7 trillion in four months. It reached its present size of $8.9 trillion back in February 2022. Portfolio buying programs are referred to as Quantitative Easing and reductions are called Quantitative Tightening programs.
 
Each month Treasury and mortgage securities mature or “roll off” out of the portfolio. In the past, the Fed has reinvested this maturing principal in new securities. Going forward, only a portion of the maturing principal will be reinvested. Starting June 1st, the Fed will not reinvest up to $30 billion in Treasuries and $17.5 billion in mortgages. Over the next three months those caps will rise to $60 billion and $35 billion per month, respectively. 
 
This rate should average $1.1 trillion per year, potentially cutting the Fed’s portfolio by one-third over the next three years. This action drains liquidity from the banking system, hurting financial activity. Interest rate increases, on the other hand, impacts Main Street borrowers. 

Comment

Markets thrive on certainty and the Fed deserves credit for improving its communications to meet Wall Street’s expectations. Interest rates have largely returned to their pre-pandemic levels. If the Fed is serious about returning the economy to its pre-pandemic growth trend it should quickly return short-term rates to 1.5% to 1.75%.  
 
But if the Fed is serious about fighting inflation, it needs to raise rates high enough to take real interest rates to near zero. That would entail moving Fed Funds to the levels of current inflation, or near 7%. We doubt the public or markets have the stomach for such a Volker-style move. In the coming months we do expect inflation rates to come down, and wage gains to hold, making it easier for the Fed to close the real interest gap. 

Summary

The current FOMC leadership has done an admirable job of communicating its plans. Powell’s clear communication of possible half percent increases and the slower speed of the portfolio reduction were cheered by markets. Shorter term interest rates fell slightly as traders were comforted that big jumps in rates, such as 0.75% or higher, are not around the corner. 
 
Increases in interest rates are already impacting home mortgage decisions and some business lending. Consumers are balking at some purchases caused by higher prices. We remain optimistic that the rate of inflation will moderate later in the year, but prices will remain elevated. 
 
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