The Fed moves from tightening to ease like an alcoholic going through the recommended 12 steps to end dependency.
Step one starts with some global financial dislocations, likely set off by Fed policy. The Fed’s reaction is that they are the central bank for the US, not the world.
Step two is when the dislocations start impacting domestic asset prices. The Fed’s reaction is to downplay market volatility and remind everyone why the word “risk” is in the term “risk markets”.
Step three comes when the Fed realises something might be amiss but, since the domestic data remain fairly strong, they figure it is enough to let everyone know that they have finished tightening for now, a “soft ease” by simply no longer tightening. This was the message from the December FOMC meeting, but Powell botched it. Realising his blunder, he reiterated the message more directly on Friday and, more significantly, added on the possibility of tapering the pace of balance sheet reduction (QT).
Step four is the first ease, but it is only a little one at first, designed to mollify the markets and satisfy the Fed staff, who still sees no recession on the horizon. Our guess is that step four will come as early as the end-January FOMC, but more likely at the mid-March meeting. Announcing a change in the pace of QT has become our best guess for how step four will be executed. Unlike so many, the Fed doesn’t see QT as the source of myriad market maladies. This leaves tapering QT as the perfect step four.
Step five is finally lowering the funds rate in earnest and usually in a bit of a panic. The Fed eventually reaches that stage because the process begins with the FOMC strangely disconnecting asset prices from their impact on growth. Powell could recognise how the negative curve will redirect credit flows and skip right to step five - cutting rates to keep the expansion on track. But he won’t.
Knowing the markets as he does and assuming markets continue to signal stress through the noise of price volatility, Fed policy reversals are consequently going to come sooner than the markets are betting. Remember too that markets severely and consistently underestimated the Fed during the tightening cycle. This first act of easing looks now to be a cut in the pace of QT, i.e. step four.
On 20 March the Fed announced that they would scale back their QT programme to $35bn per month and confirmed they would bring it to a close by the end of September.