Fed Begins Preparing Market For Inflation Fighting Focus, Minutes Give Clarity on Quantitative Tightening

FS Insight Team

This was the week of the crying dove. Lael Brainerd could be considered one of the leaders of the dovish camp in the Federal Reserve. She attended a virtual conference hosted by the Minneapolis Federal Reserve where she made it clear she views fighting inflation as a task of “paramount importance.” Markets sold off on her remarks. When Bullard is advocating hawkish action, it is one thing, however, when Brainerd is saying it they tend to pay a little closer attention. Our Head of Global Portfolio Strategy, Brian Rauscher, suggested weeks ago that dovish Fed staff would begin reflecting a hawkish pivot and laying the groundwork for more aggressive tightening than market participants were currently prepared for.

Long-dated treasuries sold off steeply after Brainerd’s appearance. Brainerd is a member of the Fed who is generally very concerned with the effect Fed policy is having on the lower-income quintiles and this was at the heart of her argument to not tighten too fast in the post-pandemic period. It is notable that she spoke to inflation as being one of the biggest threats to the financial vitality of those toward the bottom of the economic totem pole. Brainerd foreshadowed some of the insights made public with the release of the Fed minutes.

Brainerd was just the start of the new chorus of Fed messaging that appears geared toward telegraphing a much more hawkish direction than equity market participants may be prepared for. Philadelphia Fed President Patrick Harker came out and said that he was “acutely concerned” about inflation. San Francisco Fed President Mary Daly similarly took a hawkish bent. Tellingly, she said that inflation is just as harmful as “not having a job.” This should give you an idea as to which side of the dual mandate the world’s most powerful central bank is shifting its focus to. Price stability now appears to be king. Daly has been firmly in the dovish camp as well.

Tuesday’s adverse reaction was followed by the release of the meeting minutes from the March meeting where lift-off started. One major surprise in these minutes was that a large number of Federal Open Market Committee (FOMC) members favored larger hikes. In fact, the minutes said that a 50-bps hike in March would have been the committee’s preferred course of action had Russia not invaded Ukraine.

The minutes also provided the best detail on quantitative tightening that we’ve received so far. As recently as January a survey of large Wall Street players showed that the average expectation for tightening was that the committee would allow about $80 billion in securities to mature each month and roll off the balance sheet. The minutes show that the committee went more hawkish than market expectations. Officials were in general agreement that $60 billion in Treasuries and $35 billion of securities should be allowed to “roll-off” every month. Allowing assets to roll-off is not as hawkish as outright selling securities in the open market. However, that may be required if inflation proves persistently high as well. The minutes also strongly suggested there will be a 50-bps hike at the May meeting.

The pace of this quantitative tightening would about double the pace of the failed efforts in 2017-2019. Stocks were down following the release of the hawkish minutes. Former NY Fed President Bill Dudley came out with an article that was even more hawkish than the line coming out from current committee members. Bill Dudley argued in his Bloomberg Op-Ed that the Fed could not achieve the desired tightening with stock prices so high. His argument is that the confidence produced in the economic decision-making of American households by high stock prices negates or prevents the desired tightening needed to suppress inflation.

One thing that is idiosyncratic about the role of Fed governors is that they have very little staff support. You can often derive where their thinking comes from research by the staff economists and research teams that inform them in an official capacity. This little tidbit may provide some deeper insight for dedicated Fed watchers as to the rational basis for Dudley’s controversial article. You can find the report here. Details will be provided on Quantitative Tightening at the May meeting. The benchmark yield on the 10-Year Yield was 270 bps

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