The Fed’s Policy Tightening Plan: A One-Two Punch

The Federal Reserve dealt the bond market a sharp body blow on January 5th with the release of the minutes of its last Federal Open Market Committee (FOMC) policy meeting in December 2021. The Fed already had signaled it likely would hike short-term rates, perhaps starting as early as March. However, the big surprise was that the minutes also indicated that the Fed was considering quantitative tightening—shrinking its balance sheet. FOMC members Mary Daly, Christopher Waller, and James Bullard reinforced the message that the Fed was considering using the balance sheet to tighten policy along with rate hikes. The bond market reeled, with 10-year Treasury yields hitting 1.80% on an intra-day basis—the highest level in two years—before closing at 1.79%.

The 10-year Treasury yield rose to the highest level all year

The Fed’s one-two-punch strategy caught the market by surprise. Few anticipated that quantitative tightening would start so soon after rate hikes. It’s a sharp departure from Fed policies in the period following the 2007-2009 financial crisis, when the Fed waited two years after hiking rates in December 2015 to end its quantitative-easing program. With quantitative easing, or QE, the Fed buys securities—such as Treasuries and mortgage-backed securities—in order to add cash (or “liquidity”) to financial markets.

When the Fed did initiate quantitative tightening in 2017, it was a slow process. It stopped reinvesting the principal and interest on maturing bonds but capped the amount that it allowed to “roll off” the balance sheet at any time, to mitigate the impact on interest rates and the economy. This cautious approach to tightening reflected the sluggish pace of the economic recovery at the time. Job and wage growth were slow, and inflation was low.

Moreover, the process was complicated by a tightening in financial conditions from 2012 to 2016 due to a strong rise in the dollar. Consequently, it took two years for the Fed’s balance sheet to decline from $4.2 trillion to $3.6 trillion. At that point, the balance sheet still stood at 17.8% of gross domestic product (GDP), compared to the pre-financial-crisis level of about 6% of GDP. Since then, the Fed’s balance sheet has soared to more than $8 trillion, or 38% of GDP.