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The Fed: Fed’s Daly says balance sheet shrinkage could start after one or two rate hikes

San Francisco Fed President Mary Daly said Friday that the central bank could start to shrink its balance sheet after one or two rate hikes.

In a talk to the American Economics Association, Daly said she wanted the federal funds rate to be communicate the stance of policy.

“But after one or two hikes, you could imagine adjusting the balance sheet — I could,” Daly said.

Going forward, Daly said, the Fed could adjust the balance sheet first and see its impact on the economy before adjusting interest rates.

“I would prefer a flatter funds rate and more adjustment on the balance sheet to get ourselves back to a place that’s more normal on the balance sheet,” she said.

The Fed’s balance sheet doubled to close to $8.8 trillion in the wake of the COVID-19 pandemic.

Ellen Zentner, chief U.S. economist at Morgan Stanley, said Friday that the stock market “doesn’t seem to quite realize just how much Fed tightening may happen this year” because the effects of the rundown of the balance sheet have been forgotten and the Fed has yet to give details on how aggressive they might be.

In her comments, Daly said she backed gradual rate hikes.

“I would prefer to see us adjust the policy rate gradually and move into balance sheet reductions earlier. I would not prefer to do it simultaneously as some have argued,” she said.

Ideally, the balance sheet would be in the background, she said. Daly said she doesn’t want to adjust the Fed’s portfolio on a meeting-by-meeting basis. She said she didn’t want it to be “a daily part of our conversations.”

The San Francisco Fed president said she wasn’t as concerned as others about a return of the high inflation of the 1970s, During that episode, higher inflation let unions to push for higher wages — setting off a vicious upward spiral.

“I’m a little less worried, I guess, than some people are about a fearful and painful inflation spiral,” Daly said.

Daly’s remarks are notable because she was a strong supporter last year of maintaining an easy policy stance so that the labor market could return to its pre-pandemic strength. She is not a voting member of the Fed’s rate-setting panel this year.

The yield on the 10-year Treasury note TMUBMUSD10Y, 1.783% jumped Friday close to 1.8% in the wake of the December jobs report.

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