By Howard Schneider

WASHINGTON (Reuters) – The Federal Reserve should let its roughly $8 trillion balance sheet shrink next year as soon as it winds down a bond purchase program, St. Louis Federal Reserve president James Bullard said, cautioning high inflation may require more aggressive steps by the central bank including two interest rate hikes in 2022.

Bullard indicated that inflation is expected to stay at 2.8% for next year. That’s well below the Fed’s 2% goal and among the highest economic projections by Fed officials.

Bullard acknowledged that inflation would ease slightly on its own but that it will need more central bank efforts to do so. This will not require the kind of restrictions that could threaten the current expansion.

The forecasted horizon will see inflation stay at or above the target level. This is good news. Bullard spoke out about Fed projections that indicated that inflation will rise above 2% from 2024 to 2024. However, interest rates are still below what would be considered restrictive.

HIGH, BUT WHERE IS THE HIGHEST?

The Fed’s new framework creates an inflation period that is higher than the previous decade to counter low inflation. However, officials are still surprised at the sudden jump in inflation. It now looks like it will continue longer than expected. The policymakers agreed to slightly raise rates next year at their last meeting, as a way of protecting against price rises too rapidly.

“There is now a risk we are going to overachieve and be too high for too long…How much of that do we want?…That is the key question for the (Federal Open Market) Committee over the next year.”

That discussion is central to the evolution of the post pandemic economy with implications for the U.S. job market and the fate of some of the Biden administration’s core policy ideas. It will also close the book on programs that the Fed has put into place to combat the pandemic.

It has come to an agreement that the Fed will end one of its programs: $120 million in bond purchases. A plan was developed to eliminate them later this year and then end them entirely in the first month of 2022. There is still much to discuss about the pace and date for the “bond taper”, with an announcement expected at the Fed’s November meeting relying partly on future jobs.

Bullard indicated that it would be a significant shock to disrupt this process.

As a result, policymakers have begun to shift to more crucial discussions, such as raising interest rates or what to do to the Fed’s massive stockpiles in Treasury securities and mortgage-backed securities.

Bullard indicated that asset assets will probably be worth around $8.5 trillion once the Fed ceases buying new securities. The Fed bought bonds for five years after the financial crisis of 2007-2009 and the recession. Three years later, the Fed stopped buying bonds and began reinvesting proceeds from mature assets. This was until 2017.

Bullard stated that “everything could occur much quicker than it could in the previous recovery”, noting that U.S. GDP had already exceeded its pre-pandemic peak.

He suggested that we should allow the runoff from the balance sheets to begin. That could be done at the “end of the taper”, next year. That would be an ideal time…It appears like it will continue to expand strongly through next year. It is going to be in good shape by that point.

The Fed’s policymakers haven’t started these discussions yet, he stated, however, “I think it is not too early” considering the extraordinary speed of recovery and continuing concern over inflation.

Higher long-term rates would be possible if the Fed begins to reduce its holdings of more-long-term securities. This would be in conjunction with an increase in the Fed’s short-term policy rate, which will reduce central bank support to the economy.

POLICY REMAINS LOOSE

Recent Fed projections never see central bank policy actually becoming restrictive in the years ahead. In 2024 the median expected federal funds rate will be 1.8%, which is still below 2.5% in the long term. This would make it roughly neutral.

Bullard believes rates will rise slightly to 2.5% over time. However, even this, he said, would be close to his original estimate of neutral.

His outlook on an earlier pace of rate rises, with the first two increase next year, is reflective of the concern that a combination of a global demand shock and loose Fed policies creates prime conditions for faster, more persistent inflation. This, however, contradicts the belief of other policymakers who believe the pace of price hikes remains low.

This may be the case. “We will all converge into bliss at an inflation rate of 2%, and we never increase the funds rates again,” he stated. That is what we have right now. But, reality is likely to be more complicated.

His colleagues who minimize inflation risk but believe the Fed should lower rates to stimulate more job growth are among those he spoke for. He stated that “I’m not trying prejudge what the future holds.” Inflation could return to its target. It is possible that it could happen and it would be beautiful just the way it has been described.

“Inflation could also be a lot more persistent than we had hoped and in that case we will have to recalibrate how we are going to keep inflation under control.”