By Yasin Ebrahim

Investing.com — Federal Reserve officials discussed the prospect of stepping up the pace of monetary policy tightening including plans to cut the size of the central bank’s balance sheet after the May meeting, the Fed’s March meeting showed Wednesday. 

“[P]Articipants consensus that there had been substantial progress made on the plan, and the Committee is well-positioned to initiate the process to reduce the size of balance sheet as soon as May concludes,” according to Fed minutes. 

It concluded its March meeting. 16 The Federal Open Market Committee (the Fed’s rate-setting arm) raised its range from 0.25% to 0.5%.

The Fed’s decision in March was also accompanied with several projections on the path of economic growth, inflation, and unemployment. 

But it was the central bank’s estimates on rate hikes that caught many by surprise. Fed members backed six rate rises in 2022. They forecasted the benchmark rate rising to 1.9% before year end. 

Ahead of the minutes, Fed members appear to be teeing up the market for a much steeper tightening path than previously projected as inflation hasn’t shown any sign of dissipating.

Federal Reserve’s preferable inflation measure, personal consumption expenditures price index (PCE) excluding energy, increased 5.4% during the 12-month period ending March. It is now the highest gain in 12 months since April 1983.

The Fed is “prepared to take stronger action, if indicators of inflation and inflation expectations indicate that such action is warranted,” Federal Reserve Governor Lael Brainard said on Tuesday.

According to Investing.com, around 80% of traders believe that the Fed will raise rates 50 basis points during its May meeting.

Raising rates isn’t the only tool in the Fed’s monetary policy toolbox. The Fed can also shrink its nearly $9 trillion balance sheet, a move which Powell suggested last month “might be the equivalent of another rate increase.”

History proves, however, that the balance sheet reduction operation, or quantitative tightening, isn’t an easy task. 

In 2018, the Fed allowed certain bonds to ‘run off’ each month without reinvesting the principal of the bonds, primarily U.S. Treasury and mortgage-backed securities, in new securities. 

Opting for a gradual and capped approach, the Fed allowed about $10 billion of securities a month – $6 billion a month in Treasury securities and $4 billion in mortgage-backed securities a month – to roll off its balance sheet, with a view to gradually speed up the process. 

The pace of runoff reaching $50 billion per month forced the central bank to stop it in late 2019. This was after the key overnight lending rate that supports the plumbing system of the financial sector, had jumped, and this risked the stability funding markets. 

Powell, pointing to the strength of the economy, believes this time it’s different. 

The hawkish wave of remarks from Fed members hasn’t gone unnoticed. The growing possibility that the U.S. central banking will reduce the rate of economic growth and overthrow its tightening policies is being priced into the bond market, which may lead to a recession. 

Key part of yield curve: the Treasury yield over 2 years, inverted briefly recently. This is an indicator that a possible recession may be coming. 

Deutsche Bank (DE:), one of the major banks that warned the U.S. would fall into recession in the next year, amid expectation for the Fed’s decision to raise rates 50 basis points each of its three next meetings.

“The U.S. economy is expected to take a major hit from the extra Fed tightening by late next year and early 2024,” Deutsche Bank economists David Folkerts-Landau and Peter Hooper said in a report on Tuesday.