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US stocks went on a rollercoaster ride after Fed Chair Powell’s testimony signaled that the Fed “in all likelihood” will be normalizing policy, while allowing the balance-sheet runoff later this year. The Fed sees inflation lasting till mid-2022 and that is probably when they will let the balance sheet decline.

Wall Street now has a better understanding on how the Fed will normalize policy and with the balance runoff likely taking up to four meetings. After Powell’s testimony, some investors feel they got the all-clear signal to buy the dip.  The Fed’s window for tightening is complicated given inflation could finally peak during the summer and since they may not want to look political and be too aggressive removing accommodation so close to the midterm elections.

Investors are still very optimistic about three key things: Household and corporate balance sheets remain very healthy, the upcoming earnings season should be strong, and the economy will still see above trend growth even if the Fed raises rates three times and begins the balance sheet runoff in the summer.

Fed

The opening act to Fed Chair Powell’s confirmation hearing for a second term had a couple hawks, Bostic and Mester both lay the foundation for a March liftoff, while George supported an earlier balance sheet runoff.

Early this morning, Fed’s Bostic told Bloomberg, “We are ready to act to make sure that inflation does not run away from us.” He added that they “should be comfortable and looking to reduce the balance sheet fairly soon after we do our interest-rate liftoff”.

Fed’s George said, “My own preference would be to opt for running down the balance sheet earlier rather than later as we plot a path for removing monetary accommodation.”

That was a very hawkish opening act that should support the idea rates liftoff in March and the balance sheet reduction starts in June.

Powell

Fed Chair Powell’s testimony started with addressing inflation.  He reminded financial markets that supply side constraints have been very durable and persistent, highlighting the number of ships in anchor are at record levels. He explained why they were wrong about inflation being transitory, noting that the situation is unprecedented.

Powell believes the Fed will take steps towards normalizing policy this year.  Wall Street knows rate hikes are coming and expectations are now up to 85% for a March rate hike.

Regarding the labor market, Powell stated, “what we have is a labor supply problem.” The Fed can check off the maximum employment box and now just focus on inflation.

Powell noted that a decision on balance sheet reduction could take anywhere from two to four meetings, which suggests the June meeting will become the base case for many traders.

Overall, Powell was not overly hawkish as he paved the way for a lengthy debate over balance sheet reduction, with his normalization comments taking away some of the importance over tomorrow’s hot inflation report.

By Ed Moya