Balance Sheet Runoff to Start in June

• The FOMC increased the fed funds rate by one-half of a percentage point.
• The FOMC also announced plans to reduce the size of the Federal Reserve’s balance sheet starting in June.
• Inflation is much higher than the FOMC would like. The committee’s goal is to slow economic growth to bring about lower inflation, without pushing the economy into recession. With the FOMC rapidly pushing up interest rates, however, the risk of recession is elevated.

As widely expected, the Federal Open Market Committee raised the federal funds rate by one-half of a percentage point, to a range of 0.75% to 1.00%, in an effort to fight inflation. This was the first half-point increase in the fed funds rate since 2000. This the second increase in the fed funds rate in the current tightening cycle; the FOMC raised the fed funds rate by 25 basis points at its last meeting, in mid-March.

The FOMC also announced details on reducing the size of the Federal Reserve’s balance sheet. Starting on June 1, and through August, the central bank will not replace up to $30 billion per month of maturing long-term Treasurys, and up to $17.5 billion of maturing mortgage-backed securities. Starting in September the Fed will up these monthly caps to $60 billion for Treasurys and $35 billion for MBS.

The monetary policy statement noted that economic growth remains strong in the spring of 2022, even with the decline in first-quarter real GDP. In particular, the statement noted an improving labor market and strong growth in consumer spending and business investment. But the statement also noted elevated inflation due to supply and demand imbalances coming out of the pandemic, high energy prices, and “broader price pressures.”

The statement also said that the implications of the Russian invasion of Ukraine “are highly uncertain.” The invasion has pushed up inflation and is also “likely to weigh on economic activity.” The statement also noted the potential impacts of COVID-related shutdowns in China. The statement says that the FOMC “is highly attentive to inflation risks.”

The statement was approved unanimously.

The decision to increase the fed funds rate by one-half of a percentage point was widely expected. The FOMC also provided details on plans to reduce the size of the central bank’s balance. At the beginning of the pandemic, in an effort to support economic recovery, the Fed created money electronically to increase the size of its balance sheet, buying longer-term Treasurys and mortgage-backed securities. This reduced long-term borrowing costs throughout the economy and supported the recovery.

But now, with inflation much higher than the FOMC’s 2% objective, the committee is working to increasing borrowing costs in an effort to cool off economic growth. Allowing longer-term Treasurys and mortgage-backed securities to mature and roll off the Fed’s balance sheet is putting upward pressure on long-term interest rates. The yield on the 10-year Treasury note, which fell to below 1% in 2020, is now almost 3%. Similarly, the interest rate on a typical 30-year fixed-rate mortgage has increased from below 3% in 2020 to above 5% currently.

PNC expects the FOMC to continue to increase the fed funds rate through 2022 and into 2023, increasing short-term borrowing costs. There will likely be another 50 basis point hike at the FOMC’s next meeting, in mid-June, with the rate set to end this year at above 2%, and end next year close to 3%. This would be above the neutral rate; that is, at that level, the fed funds rate would be restraining economic growth.

Higher interest rates throughout the economy will eventually lead to slower growth in consumer spending, particularly on big-ticket items, and in business investment, as well as a weaker housing market. But the FOMC has a difficult task ahead. Their hope is to raise interest rates by enough to slow economic growth and reduce inflationary pressures, but not by so much as to cause a recession—an outright contraction in the U.S. economy. That task has only gotten more difficult with the Russian invasion of Ukraine, which has added to U.S. inflation, but is also likely to weigh on U.S. growth, through higher energy prices and a weaker European economy. The most likely outcome over the next couple of years is still expansion, albeit weaker in 2023 and then again in 2024.

But the risks of a Fed misstep have increased, and it may even be that the only way the central bank can slow inflation is to engineer a (hopefully) mild recession. With current solid fundamentals, in particular a very strong labor market, if a recession does come it would likely not be until 2023 or even 2024. The probability of recession over the next couple of years is around 30%, up from around 15% before the invasion of Ukraine.

PNC’s baseline forecast is for economic growth of around 3.5% this year, with weaker growth in 2023 and 2024. Core PCE inflation is expected to slow to below 4% by the end of this year, and to the Fed’s objective of around 2% by the end of 2023. With average monthly job growth of about 300,000 through the rest of this year, the unemployment rate will move even lower in the months ahead, to its lowest level in 50 years, even as rising wages bring some people who dropped out of the labor force in the wake of the pandemic back into the job market.

Risks to the outlook remain tilted to the downside, including further supply-chain disruptions, a more significant slowing in growth from the Ukraine-Russia conflict, and continued high inflation that would force the FOMC to raise interest rates even more aggressively than in the baseline forecast.

The PNC Financial Services Group, Inc. is one of the largest diversified financial services institutions in the United States, organized around its customers and communities for strong relationships and local delivery of retail and business banking including a full range of lending products; specialized services for corporations and government entities, including corporate banking, real estate finance and asset-based lending; wealth management and asset management. For information about PNC, visit www.pnc.com.