A rapid one-two punch of interest-rate hikes and balance-sheet reduction from the Federal Reserve risks unsettling bond and stock markets that have already taken a beating.

The effects on markets and the economy of combining the two aspects of monetary tightening in quick succession—something it hasn’t done before—are unknown, and investors are telegraphing their concern. The Nasdaq Composite Index slid more than 8% over the past 10 trading sessions, while Treasuries are down 2.3% this month.

“The scale of what they’re contemplating now is completely unprecedented,” said Janice Eberly, a former Treasury Department official now at Northwestern University. “It’s prudent to gauge the market reaction, especially before moving the balance sheet in concert with interest-rate changes.”

Fed Chairman Jerome Powell and his colleagues would like to see some tightening of financial conditions to take a bit of the edge off the robust economy and help bring down decades-high inflation. A retreat in asset prices after equities and home prices hit records last year would help that process, as long as it didn’t turn into a destabilizing slump that ended up hurting the economy.

Making that task trickier: The Fed has only scaled back its stockpile of bonds once before, in 2017-2019, so there’s not much to go on to try to calculate the impact of a bigger, swifter quantitative tightening this time around. 

New York Federal Reserve Bank President John Williams expects long-term rates to “move up somewhat” over time as the central bank downsizes its balance sheet. But he acknowledged last week that it was “pretty uncertain” how big the impact of such quantitative tightening would be. “We have to be humble,” he told the Council on Foreign Relations Friday.

One of his predecessors, William Dudley, expects the process to be smooth. Steady communication of Fed plans will help, as will a liquidity backstop that the central bank put in place last year. The standing repo facility, as it’s called, gives banks an easy method of swapping Treasuries for cash—a safety valve that can help avert the squeeze seen in 2019.

Yet investors ascribe much more “tightening power” to balance-sheet drawdowns than some Fed analysis does, according to Deutsche Bank AG chief U.S. economist Matthew Luzzetti—raising the risk of unexpected selloffs in risk assets.

With traders increasingly pricing in a March liftoff for rate hikes followed within months by the start of the Fed running down its bond portfolio, stock investors have become increasingly leery. 

Back in 2017, the Fed began normalizing its balance sheet almost two years after it lifted its short-term policy rate from near zero. And it reduced its bond inventory in baby steps, starting the monthly runoff at $10 billion and slowly and steadily increasing it to $50 billion a year later. 

Policy makers, including Powell, have made clear they’ll be going faster this time.

The monetary mavens have said that a different approach is justified: The economy is stronger than it was back then, inflation is a lot higher and the balance sheet is much bigger. What’s more, the Fed holds $326 billion of Treasury bills that could come off the balance sheet within months if the proceeds are not reinvested.

"By midyear, we expect the FOMC will recognize that they still will need to do more to give the best chance of ultimately achieving their 2% target," said Anna Wong, chief U.S. economist at Bloomberg. "As a result, the committee will likely hike five times this year. We currently expect balance-sheet run-off to begin in third quarter of 2022, with a huge band of uncertainty around that timing."

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