- As expected, Fed maintained the target range at 1.00%-1.25% and announced it will start shrinking its balance sheet ('quantitative tightening') next month.
- More interestingly – and in line with our expectations as written in our preview - the Fed maintained its signal of one more additional hike this year and three hikes next year and made no changes to inflation wordings in the statement.
- Markets interpreted this hawkishly by sending EUR/USD lower and US Treasury yields higher. Markets are now pricing 60% probability of a December rate hike. The dip in EUR/USD should prove shallow and short-lived
- Process of reducing the balance sheet in line with what the Fed has previously communicated but we were surprised that the Fed did not communicate a target for the balance sheet.
Fed still expects one more hike this year and three next year
It was not a big surprise that the Fed kept the target range unchanged at 1.00%-1.25% and announced 'quantitative tightening' will begin in October.
More interestingly and in line with our expectations as written in our preview, the Fed maintained its current policy signal, as the median 'dots' were unchanged at one additional hike this year and three hikes next year and the Fed did not make changes to inflation wordings in the FOMC statement despite low inflation. The Fed still says it is monitoring inflation 'closely' and Yellen repeated at the press conference that she thinks the low inflation is 'transitory'. Markets had expected a more dovish Fed, so in terms of market expectations (but not ours), this was a 'hawkish hold' leading to a stronger dollar and selloff in US fixed income markets.
The statement and dots confirm our view that while the four most dovish members (probably Bullard, Brainard, Evans and Kashkari, in our view) are still concerned about low inflation and do not think it is appropriate to raise rates further this year, core FOMC members still believe that above-trend growth and a tighter labour market will lead to higher wage growth and hence inflation eventually.
December hike likely due to low unemployment rate
Most Fed members putting more weight on labour market data relatively to inflation data is the main reason why we still think the Fed will hike in December. In other words, it is still the belief in the Phillips curve that dominates the Fed. However, we still see a risk Fed will pause its hiking cycle next year due to low inflation, which may not be just 'transitory' given the low inflation expectations, although it requires the Fed to put more weight on its inflation mandate. The reason for this is that tightness of the labour market is not the only factor determining wage growth, as second-round effects after many years with low inflation have hit wage growth. When employees expect inflation to remain low, they can live with low wage growth, as real wage growth may still be solid, making it less likely inflation will reach the target (see also Strategy: Central banks consider leaving the party, 30 June).
Our base case is currently two hikes next year assuming the Fed continues to put more weight on labour market and growth data. At the moment, the markets price in more than 62% probability of a December Fed hike (up from 50% before the meeting) and 1.8 hikes before year-end 2018. However, as we wrote in our preview, it is more difficult to forecast what the Fed does next year in terms of monetary policy given the four vacant seats in the Board of Governors. For a more thorough debate on this issue, see page 3 in our FOMC preview: Fed to announce QT and still signal one more hike this year, 15 September.
QT set to begin in October but no balance sheet level target yet
On the balance sheet, most was in line with expectations: This means that caps for Treasuries will begin at USD6bn per month and increase by USD6bn at three-month intervals until it reaches USD30bn per month and the caps for mortgage-backed securities will be set at USD4bn per month initially and increase USD4bn at three-month intervals until it reaches USD20bn per month. Given the outlined cap-structure, Fed will still be a fairly active buyer of Treasuries likely reinvesting around USD200bn in Treasuries during 2018 (versus USD216bn last year and USD176bn projected this year). For more details see Fed's quantitative tightening details, 19 June.
However, we were a bit surprised that the Fed did not announce how much it wants to lower its balance sheet (or alternatively, for how long it wants to continue QT). It seems like the Fed wants to keep flexibility to adjust along the way if necessary, perhaps because the Fed is still concerned about a repetition of something like the taper tantrum in 2013. We still think that it is not a trivial question how much the Fed can lower the balance sheet due to increasing regulation, something the Fed has also touched upon previously, see Research US: Fed's regulatory hurdle for starting quantitative tightening, 13 March. In the addendum from June, however, it is mentioned that the level of the quantity of reserve balances was also mentioned as it 'will reflect the banking system's demand for reserve balances and the Committee's decisions about how to implement monetary policy most efficiently and effectively in the future. The Committee expects to learn more about the underlying demand for reserves during the process of balance sheet normalization
Longer-run 'dot' revised down again
The longer-run dot was revised down from 3.00% to 2.75%, which we wrote in our preview was likely, as the Fed has once again become less optimistic on how much the natural rate will increase in coming years due to higher productivity growth. This is really interesting given the theoretical debate within the Fed (and actually also at the ECB and Bank of England) about the level of the so-called neutral rate (simply put, it is the rate which should prevail when the output gap is closed and growth is on trend), which the longer-run dot reflects. This means that the Fed now thinks that the level at which US yields should trade in equilibrium is not as high as previously expected. Also very interesting, Fed Chair Yellen said that the 2.75% estimation is still based on the expectation of an increasing neutral rate, as the current level of the neutral rate is lower than 3%. Yellen repeated at the press conference that she thinks monetary policy is currently close to neutral (meaning that the current Fed funds rate is close to the current neutral rate and hence that monetary policy is soon neither expansionary nor contractionary), hikes further out are due to an increasing neutral rate. If the neutral rate does not increase as expected, it means that the hiking cycle may end sooner than most analysts expect. As we wrote in our preview, it seems like markets buy into that story given the very soft pricing of the Fed, partly reflecting that investors do not expect a pickup in the neutral rate in coming years.
FX. Dip in EUR/USD should be shallow and short-lived
EUR/USD fell below 1.19 on the Federal Reserve statement. Yellen's comments at the following press conference sent the pair further down and firmly below 1.19. It serves to show that while EUR/USD has been buoyed by strong EUR momentum as capital flows have started to reverse, the cross is not immune to continued tightening of US monetary policy. As the market is now pricing 60% probability of a December rate hike, there should be limited further support to the USD from tightening of US monetary policy, though. Hence, the dip in EUR/USD should prove shallow and short-lived and we look for it to recover to 1.20 in the short term. Furthermore, we stick to our 12M forecast of 1.25. USD liquidity could, however, start to tighten substantially around mid-2018 when Federal Reserve's balance sheet runoff accelerates. That could lead to a widening of EUR/USD CCS and increase cost hedging USD assets and income.