The Fed Knows What It Needs to Do. Now Comes the Tricky Part.

(Bloomberg Opinion) -- The Federal Reserve's pivot from easing monetary policy to tightening is nearly complete. That leaves a number of questions about how the central bank will accomplish its goal, from timing to magnitude to mix.

Why did Chair Jerome Powell and the Federal Open Market Committee statement provide so little forward guidance on the likely path of short-term rates? Both signaled a March rate increase was almost certain, but there was very little beyond that.

Partly this reflects the uncertainty of the economic outlook. The Fed has little experience with economic recoveries during pandemics. This is underscored by its forecasting errors concerning the persistence and breadth of inflation and the degree of slack in the U.S. labor market.

But it also reflects the fact that forward guidance — laying out what you are likely to do in the future — is less useful once you have lifted off and regained the ability to adjust short-term interest rates — up or down and more quickly or slowly — in response to changes in economic circumstances.

In contrast, when you are stuck at the zero lower bound for interest rates, forward guidance is more attractive because the other options are so limited. For example, by committing to keeping short-term rates unchanged until certain economic conditions are satisfied, which is what the Fed did, it is possible to influence short-term rate expectations and put downward pressure on long-term rates. Doing so eases financial conditions and supports economic activity.

We'll still have a weak form of forward guidance for the path of short-term interest rates in the Fed's quarterly Summary of Economic Projections. But these don't commit the Fed to anything, nor do they represent the FOMC's outlook — the SEP is just a collection of individual forecasts.

What are the prospects for a 50-basis-point increase in the federal funds rate at the March meeting?

The likelihood is minimal for several reasons. First, it would surprise market participants. Federal funds futures prices now imply about a 20% probability of such a move. This is important because Powell strongly believes that surprising markets is not a good way to conduct monetary policy. Surprises create confusion about how the Fed will respond in the future as the economic outlook changes. That uncertainty, in turn, loosens the linkage between monetary policy and its impact on financial market conditions, which determine how monetary policy affects economic activity.

Second, history is against it. The last time that the Fed raised the federal funds rate target by 50 basis points was in May 2000.

Third, what's the motivation for “shock and awe”? Market expectations and the Fed's forecast are broadly aligned. The Fed doesn't need to do something surprising to reset market expectations.

What are the prospects for rate increases at consecutive meetings?

That is a completely different kettle of fish. It's priced in; its consistent with the hawkish tone of Powell's press conference; and its appropriate given the economic outlook and the starting point. Markets are currently priced for about 125 basis points of increase in the federal funds rate target this year. While this is reasonable, the risk is that Fed officials will have to do considerably more.

How will the Fed normalize its balance sheet, and when will that begin?

The Fed will use the same playbook as last time: First, it will announce a plan that phases in caps on the monthly pay-down rate for Treasuries and agency mortgage-backed securities and then subsequently pull the trigger. Powell indicated that more FOMC discussion was required to settle on the details and that balance sheet runoff would start only after the central bank raises the federal funds rate. That suggests that the June meeting will be the earliest start for balance sheet normalization.

Fed officials have also indicated that the federal funds rate will be the primary tool of monetary policy. For that to be feasible, the FOMC needs to have some room to cut the federal funds rate should the economy suffer an adverse shock. Thus, the start might be somewhat later if Fed officials decide they want to raise the federal funds rate a bit higher before pulling the trigger. Last time, the process didn't begin until after the federal funds rate target had reached 1% to 1.25%.

Once the FOMC begins to shrink its the nearly $9 trillion balance sheet, the process will run on autopilot in the background. The trajectory will not change unless an economic shock pushes the federal funds rate back to zero and the Fed needs to use quantitative easing again to make monetary policy more accommodative. Barring that, the balance sheet will diminish until the supply of reserves in the banking system shrinks until it is modestly above the underlying demand. Last time around, this was about $1.5 trillion of reserves. With the subsequent growth of the economy and banking system, presumably it will be somewhat higher this time.

What is the purpose of the caps on Treasury and agency MBS redemptions?

The caps have much different roles for Treasuries compared with agency MBS. The amount of Treasury maturities can vary significantly month to month, with Treasury maturities much higher during the middle month of each quarter. The caps limit the amount of runoff in those months to avoid disrupting the Treasury's funding activities.

In contrast, the agency MBS caps are in place to limit disruption to the mortgage market in those situations when a sharp decline in long-term rates generates a surge in refinancing activity. If rates are dropping sharply, the economic outlook is deteriorating. That would not be a time when you would want a sharp increase in the pace of redemptions, which would happen if there was no cap in place.

Why not use the balance sheet more actively?

There are two reasons. First, it creates a communications nightmare. If two tools are both in play, how do you explain why you are using one instead of the other. Second, the FOMC has much more confidence about how changes in the federal funds rate affect financial conditions and the economy than it does about changes to the balance sheet. If you don't have confidence about the magnitude of the impact, then it's best to put it in the background operating at a steady pace.

By relying mostly on increasing short-term rates, isn't there a greater risk that the Fed could invert the yield curve and cause a recession?

While an inverted yield curve has been an excellent predictor of future recessions, that relationship is not causal in any meaningful way. The yield curve inverts when monetary policy becomes tight and market participants expect the economy to slow and short-term rates to fall in the future.

Moreover, a higher federal funds rate will not necessarily lead to an inverted yield curve. If inflation is higher for longer, short-term rates will need to be higher. As these expectations are formed, long-term rates will also move up.

Isn't there a contradiction within the Fed's Principles for Reducing the Size of the Federal Reserve Balance Sheet? On the one hand, they say that the securities holdings will be reduced “primarily by adjusting the amounts reinvested,” but on the other that “In the longer run, the Committee intends to hold primarily Treasury securities. …”

If the Fed eschews selling agency mortgage-backed securities, it will be a painstakingly slow process to transform the Fed's securities holdings to primarily Treasuries. This is because these securities mostly consist of 30-year fixed-rate mortgages that won't be paid off in full until decades in the future. Repayment rates are determined by principal amortization and the prepayment of mortgages when people sell their homes or refinance their mortgages. With mortgage rates likely to rise further, refinancing activity will likely be low. This is likely to limit the amount of agency MBS prepayments to around $30 billion a month or so. That's a drop in the bucket relative to the Fed's $2.7 trillion in holdings. This means that if the Fed wants to transition relatively quickly to an all-Treasury portfolio, agency MBS sales will need to be put on the table at some point.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Bill Dudley, a Bloomberg Opinion columnist and senior adviser to Bloomberg Economics, is senior adviser to the Griswold Center for Economic Policy Studies at Princeton University. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.