Yesterday, the Federal Reserve announced it would raise the target range for the Fed funds rate 50 basis points (bps) to 0.75%–1.00%. It also formalized plans to reduce its $9 trillion balance sheet starting June 1, with an initial monthly cap of $47.5 billion, rising to $95 billion per month on September 1. At that pace, the Fed’s balance sheet may shrink by about $500 billion this year, and fall from 36.6% of GDP in first quarter 2022 to 23% (about $6.6 trillion) by the end of 2024, approaching pre-pandemic levels.
Both decisions were widely expected, but nevertheless mark a shift in Fed policy. The Fed, which typically raises rates in increments of 25 bps, had only previously raised rates by 50+ bps five times since 1990, most recently in 2000. The Fed now plans to tighten monetary policy more aggressively than it expected in January to address inflation, which hit another 40-year high in March. US Treasury yields have increased sharply this year in response to the change in interest rate expectations. Ten-year yields are up 141 bps in 2022 and briefly traded above 3% in recent days for the first time since 2018.
However, US Treasury yields fell, and US equities rallied on Wednesday before reversing those moves today. The initial positive reaction was likely in response to Fed Chair Jerome Powell’s somewhat dovish comments in the press conference. Powell seemed to rule out the possibility of more aggressive 75-bp rate hikes, though he left the door open for additional 50-bp rate hikes at future meetings. According to futures markets, the probability of a 75-bp rate hike at the June policy meeting fell substantially following Powell’s comments.
The Fed has a challenging job ahead as it attempts to tighten monetary policy enough to bring inflation under control, but not too much as to push the economy into recession. While inflation may be peaking, historically tight labor markets, Russia’s invasion of Ukraine, and new COVID-19 lockdowns in China all threaten to keep inflation high. Amid this backdrop, policymakers are likely to lean more toward controlling inflation than preventing a slowdown. Given uncertainty about the inflation outlook and Fed policy, we believe Treasury yields can still move higher.