Rate normalization is almost a go.
There’s no returning to our pre-pandemic lives, but the Federal Reserve is well on its way to normalization.
We prefer to conceptualize the Fed’s removal of accommodative policy this way, rather than thinking of it as tightening, because it isn’t. Not when its balance sheet is enormous and rates are pinned near zero. Of course, cash managers and the broad money markets are elated about the end of the asset-purchase program and the prospect of a slew of hikes in the federal funds target range likely to start in March. But the journey to business as usual will be long.
In his presser following the Federal Open Market Committee meeting last week, Chair Jerome Powell’s hawkish dialogue offered the guidance the noncommittal, almost milquetoast statement lacked. He was forceful enough that the futures market is flirting with projecting five hikes this year—much faster than the pace seen in the cycle that began in late 2015. We are not that bullish, but do think increases in March and May are possible.
Even if the Fed raises rates in a nonperiodic manner, it likely will stick to its preference of acting sequentially—waiting to reduce its balance sheet until it has the fed funds rate at, or at least close to 2% (it indicated the process will be passive, letting securities roll off). But Powell made clear the situation is fluid. If the bond market is not reacting well or an externality arises, he said policymakers will alter the course.
Also due to normalize is the Fed’s Overnight Reverse Repo Facility. We anticipate the committee to raise it in concert with hikes of the fed funds target range to keep it at 5 basis points above the lower bound of the new span. Interest on Excess Reserves likely would be increased by the same amount. Usage of the facility continues to be extraordinarily high, and that, too, will take time to unwind. The Fed would like to get out of that market, but banks will be in no hurry to finance it again because of the miniscule margins.
A complete Fed board has not been the norm for many years, but President Biden moved to fill it last month. He tapped current governor Sarah Bloom Raskin (for vice chair for supervision) and economists Lisa Cook and Philip Jefferson. At first blush, none of the nominees stand out as being situated far from center on policy, though Raskin has been outspoken on climate-based financial risks.
As the front of yield curves steepen, we look forward to a return of our “barbell” approach to portfolio construction. This means balancing purchases on the front end of relevant curves for liquidity with those closer to a year out for yield. To facilitate this, in January we shortened the weighted average maturities of our government money market funds to a target range of 25-35 days and our prime and tax-free money funds to 30-40 days.