- The FOMC raised its FF rate target as expected by 25 bps to 1-1.25%
- Press statement showed little surprises; Yellen sees inflation going higher
- Fed’s median rate projections for 2017, 2018 unchanged; 2019 marginally lower
- Fed intends to start balance sheet tapering soon if economy evolves as expected
- Starting cap for tapering $6B/month for Treasuries & $4B for MBS
- At full speed (after 1 year) tapering amounts to $50B/month or 600B/year
FOMC unmoved by slower inflation
The FOMC as expected raised its Fed funds target range by 25 basis points to 1%‐1.25%, the third consecutive quarterly rate increase. The press statement didn’t contain much surprises compared to the March and May statements. Growth projections were virtually unchanged from the March ones, the unemployment rate was substantially revised lower for the years up to 2019 and the long run employment rate was lowered 0.1%‐point to 4.6%. The FOMC lowered the inflation projection for end 2017 to 1.6% from 1.9% in March, but kept it unchanged for headline and core PCE inflation at 2% for 2018 and 2019. The statement recognizes that inflation has declined recently and is running somewhat below 2%. The FOMC said it expected inflation to remain below 2% in the near term, but to stabilize around 2% over the medium term. Yellen attributed the recent decline in inflation to idiosyncratic reasons like wireless services prices and prices for prescription drugs. She however maintained her view that the Philips curve, while rather flat, is still valid. When the labour market tightens further, she expects higher wages growth and ultimately higher inflation. She summarized that the growth and inflation environment was broadly the same as in March. Inflation developments would, however, be followed closely , suggesting that some governors are concerned about recent inflation readings.
FOMC sticks to its rate path projection
The FOMC policy outlook (dot plot) was virtually unchanged. Before the end of 2017, the Fed expects one more rate hike (1.375%) and 3 for 2018 3 (2.125%). In 2019, the the Fed expects 3 rate hikes (to 2.875%) instead of 3.5 hikes (to 3%) in March. This was mainly due to the number of participants (16 instead of 17). Looking to the individual dots, it looks that 1 governor of the majority (Evans? Brainard?) changed his 2017 view from 3 to 2 rate hikes (which took already place). So, the FOMC as a Committee stuck to its projected path of gradual rising rates over the next years.
Tapering balance sheet to start in 2017
The FOMC confirmed its intention to start winding down its balance, by not fully reinvesting the proceeds of the maturing assets, this year, if the economy evolves as expected. We suspect that the FOMC wants to raise rates once again in September and start its balance sheet run‐off in early Q4, suggesting unchanged rates in December to gauge the impact of the tapering. The Fed published an addendum to the policy normalization principles and plans
Initial run-off small ($10B/month)
The central bank will shrink its balance sheet (and at the same time the reserves held by financial institutions at the Fed) by decreasing its reinvestments, but only to the extent the payments of the maturing assets it receives exceed a gradually rising cap. For Treasuries, the cap will be $6B/month at the start and will increase in steps of $6B at 3‐month intervals over 12 months until it reaches $30B/month. For Agency and MBS debt, the initial cap is $4B/month to be increased over 1 year to $20B/month. Once these maximum amounts are reached, the caps remain in place until the desired size of the balance sheet is reached. That desired size will be decided later on and depends on the way the Fed wants to conduct its monetary policy. Yellen said that the post‐crisis policy setting was working very well, suggesting the Fed may not go back to its pre‐crisis system of open market operations. This means that the size of the balance sheet (and the reserves), after normalization, will be appreciable below levels seen in recent years, but larger than before the crisis.
Fed Fund rate to remain main tool
The FOMC affirms that the FF rate will remain the main tool to adjust its policy, but it is ready to resume reinvestments if a material deterioration in the economic outlook were to warrant a sizeable reduction in the FF target. It would also re‐use the QE tools, including altering the size and composition of the balance sheet if the FF rate would be near the zero bound and more accommodation was needed.
How long will it take to normalize?
After one year (end 2018?), the reduction of the reinvestments would amount to $50B/month or $600B/year (first year $300B). If the current $4.5 T balance would be lowered to $2.5T (Bernanke suggestion), it would take less than 4 years (to about end 2021) to reach the end of the normalization if our $2.5 T hypothesis is correct..
Market reaction subdued after FOMC
US Treasuries sharply rallied in the afternoon on weak CPI and retail sales. After the FOMC, they returned some of the gains. In a daily perspective, the curve was still substantially lower and flatter with yields down between 3.2 bps and 9.9 bps. Markets clearly don’t believe that the FOMC will be able to increase rates as they project it in the dot plot. Probabilities for an additional 2017 rate hike in September are 21%, and 36% for December. For end 2018, markets expect a 1.50% FF rate versus 2.125% for the Fed. End 2019 markets don’t even discount an extra rate hike. So, the gap between markets and the Fed remains as large as before.
The dollar lost substantial ground on the afternoon data releases, but recouped them after the FOMC. Only USD/JPY remained slightly below opening levels.
US equities ended the session narrowly mixed with the Dow eking out marginal gains, the S&P 500 nearly unchanged and the NASDAQ registering modest losses
