Fed begins balance sheet normalization and signals more rate hikes, as expected
The Federal Reserve left its target interest rate unchanged, but announced that it will begin to gradually shrink its balance sheet in October. The monthly pace of the reduction will initially be USD 10bn and increase to USD 50bn in the course of next year. At the same time, the updated Summary of Economic Projections did not contain any meaningful changes compared to June. In particular, Fed officials continue to see one additional rate hike this year, followed by another three increases in 2018. The Committee did, however, further lower its estimate for the longer-run equilibrium rate.
It is a historic day for the Federal Reserve and global monetary policy. After central banks around the world have been trying to contain the fallout from the Great Recession by aggressively using unconventional policy tools, the Fed is now beginning to unwind its easy money policies. While it is too early to say how markets will ultimately cope with the balance sheet normalization over the next few years, first indications are very reassuring: stocks remain very elevated while 10Y Treasury yields are firmly in the middle of their five-year range. At this point it seems safe to say that the Federal Reserve’s unconventional policy approach has been a great success. Not only did it help the US to exit the Great Recession faster than many other countries, but it did so without causing any of the nasty unexpected consequences (such as hyperinflation) that had been predicted at the time by doomsayers. With those positive experiences made, one can be certain that quantitative easing will remain an important part of every central bank’s toolbox for the years to come.
Back to the current situation: As laid out before, the Fed will reduce its securities holdings by reinvesting proceeds from maturing and prepaid securities only to the extent that they exceed gradually rising caps. For Treasuries, the monthly caps will initially be USD 6bn. They will increase in steps of USD 6bn at three-month intervals until they reach USD 30bn. For agency debt and mortgage backed securities, the monthly caps will initially be USD 4bn. They will increase in steps of USD 4bn at three-month intervals until they reach USD 20bn.
That implies that the Fed’s balance sheet will initially shrink by USD 10bn per month during fourth quarter 2017. That pace will accelerate to USD 20bn in first quarter 2018 until it reaches USD 50bn in the fourth quarter 2018. If the Fed follows that path, we calculate that the balance sheet will shrink from currently USD 4.5tn to USD 2.8tn by the end of 2020. From late 2021 on, the balance sheet will then have to rise again, as the Federal Reserve’s liabilities continue to grow.
To understand this, let’s have a quick look at the liability side of the balance sheet. The latter mostly comprises currency in circulation and reserve balances; combined, they account for 85% of total liabilities. Currency in circulation has grown over the past decade or so by close on 6% per annum. Interestingly, that growth rate has not slowed down in recent years despite the increased usage of credit cards and other payment services. We thus assume that currency in circulation will continue to grow at that pace for the time being, an assessment that is shared by the Federal Reserve’s staff.
The other important component is the Federal Reserve’s reserve balance. Currently, there are USD 2.3tn in reserves on the balance sheet, compared to essentially zero before the Fed began its QE programs. While there is unanimous agreement that the Fed will not reduce its excess reserve holdings all the way back to zero in the coming years, a target level has not been named, either. For our normalization scenario, we are assuming a target for the reserve balance of USD 750mn. That is somewhat less than the USD 1mn envisaged by former Fed Chairman Bernanke.
In addition to the announcement regarding the balance sheet, the Federal Reserve remains on track for further rate hikes. While the Committee left its target rate unchanged this time, the FOMC members’ updated interest rate projections continue to show an additional rate hike at the end of this year, followed by another three hikes in 2018. in fact, twelve of the sixteen Committee members project another hike before the end of this year.
There was, however, a further downgrade of the longer-run equilibrium rate. The median dot for the latter came down to 2.8% from 3.0% in June, as several FOMC members have lowered their estimate for the equilibrium rate. In line with that, the median interest rate projection for year-end 2019 was lowered to 2.7% from 2.9%. And the newly-introduced dot for 2020 stands at 2.9%, i.e., a tad higher than the equilibrium rate.
The updated economic projections did not contain any major changes compared to June, either. There were some small upward revision to GDP growth, and small downward revisions to the jobless and the inflation rates. The fact that the Committees’ median core inflation forecast for year-end 2018 moved down to 1.9% from 2.0% is probably the most noteworthy change, as it indicates dwindling confidence among FOMC members that the inflation target will be reached before the end of next year. At the same time, one has to keep in mind that the median is only one among several statistical summary measures. The central tendency (which excludes the highest and lowest three forecast) for the year-end 2018 core inflation number remained at an unchanged 1.8%-2.0%, which in turn suggests that the outlook has not changed dramatically.
Last but not least, the post meeting statement left the most relevant passages unchanged as well. It, in particular, reiterated the Committee’s expectation “that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate” – which is perfectly in line with the dot-plot. The main changes in the statement all relate to the potential impacts of the latest hurricanes on the economy as well as on inflation:
The Federal Reserve left its target interest rate unchanged, but announced that it will begin to gradually shrink its balance sheet in October. The monthly pace of the reduction will initially be USD 10bn and increase to USD 50bn in the course of next year. At the same time, the updated Summary of Economic Projections did not contain any meaningful changes compared to June. In particular, Fed officials continue to see one additional rate hike this year, followed by another three increases in 2018. The Committee did, however, further lower its estimate for the longer-run equilibrium rate.
It is a historic day for the Federal Reserve and global monetary policy. After central banks around the world have been trying to contain the fallout from the Great Recession by aggressively using unconventional policy tools, the Fed is now beginning to unwind its easy money policies. While it is too early to say how markets will ultimately cope with the balance sheet normalization over the next few years, first indications are very reassuring: stocks remain very elevated while 10Y Treasury yields are firmly in the middle of their five-year range. At this point it seems safe to say that the Federal Reserve’s unconventional policy approach has been a great success. Not only did it help the US to exit the Great Recession faster than many other countries, but it did so without causing any of the nasty unexpected consequences (such as hyperinflation) that had been predicted at the time by doomsayers. With those positive experiences made, one can be certain that quantitative easing will remain an important part of every central bank’s toolbox for the years to come.
Back to the current situation: As laid out before, the Fed will reduce its securities holdings by reinvesting proceeds from maturing and prepaid securities only to the extent that they exceed gradually rising caps. For Treasuries, the monthly caps will initially be USD 6bn. They will increase in steps of USD 6bn at three-month intervals until they reach USD 30bn. For agency debt and mortgage backed securities, the monthly caps will initially be USD 4bn. They will increase in steps of USD 4bn at three-month intervals until they reach USD 20bn.
That implies that the Fed’s balance sheet will initially shrink by USD 10bn per month during fourth quarter 2017. That pace will accelerate to USD 20bn in first quarter 2018 until it reaches USD 50bn in the fourth quarter 2018. If the Fed follows that path, we calculate that the balance sheet will shrink from currently USD 4.5tn to USD 2.8tn by the end of 2020. From late 2021 on, the balance sheet will then have to rise again, as the Federal Reserve’s liabilities continue to grow.
To understand this, let’s have a quick look at the liability side of the balance sheet. The latter mostly comprises currency in circulation and reserve balances; combined, they account for 85% of total liabilities. Currency in circulation has grown over the past decade or so by close on 6% per annum. Interestingly, that growth rate has not slowed down in recent years despite the increased usage of credit cards and other payment services. We thus assume that currency in circulation will continue to grow at that pace for the time being, an assessment that is shared by the Federal Reserve’s staff.
The other important component is the Federal Reserve’s reserve balance. Currently, there are USD 2.3tn in reserves on the balance sheet, compared to essentially zero before the Fed began its QE programs. While there is unanimous agreement that the Fed will not reduce its excess reserve holdings all the way back to zero in the coming years, a target level has not been named, either. For our normalization scenario, we are assuming a target for the reserve balance of USD 750mn. That is somewhat less than the USD 1mn envisaged by former Fed Chairman Bernanke.
In addition to the announcement regarding the balance sheet, the Federal Reserve remains on track for further rate hikes. While the Committee left its target rate unchanged this time, the FOMC members’ updated interest rate projections continue to show an additional rate hike at the end of this year, followed by another three hikes in 2018. in fact, twelve of the sixteen Committee members project another hike before the end of this year.
There was, however, a further downgrade of the longer-run equilibrium rate. The median dot for the latter came down to 2.8% from 3.0% in June, as several FOMC members have lowered their estimate for the equilibrium rate. In line with that, the median interest rate projection for year-end 2019 was lowered to 2.7% from 2.9%. And the newly-introduced dot for 2020 stands at 2.9%, i.e., a tad higher than the equilibrium rate.
The updated economic projections did not contain any major changes compared to June, either. There were some small upward revision to GDP growth, and small downward revisions to the jobless and the inflation rates. The fact that the Committees’ median core inflation forecast for year-end 2018 moved down to 1.9% from 2.0% is probably the most noteworthy change, as it indicates dwindling confidence among FOMC members that the inflation target will be reached before the end of next year. At the same time, one has to keep in mind that the median is only one among several statistical summary measures. The central tendency (which excludes the highest and lowest three forecast) for the year-end 2018 core inflation number remained at an unchanged 1.8%-2.0%, which in turn suggests that the outlook has not changed dramatically.
Last but not least, the post meeting statement left the most relevant passages unchanged as well. It, in particular, reiterated the Committee’s expectation “that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate” – which is perfectly in line with the dot-plot. The main changes in the statement all relate to the potential impacts of the latest hurricanes on the economy as well as on inflation:
- “Hurricanes Harvey, Irma, and Maria have devastated many communities, inflicting severe hardship. Storm-related disruptions and rebuilding will affect economic activity in the near term, but past experience suggests that the storms are unlikely to materially alter the course of the national economy over the medium term.”
- “Higher prices for gasoline and some other items in the aftermath of the hurricanes will likely boost inflation temporarily; apart from that effect, inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee's 2 percent objective over the medium term.”
This is a good reminder that all these forecast need to be taken with an even larger-than-usual pinch of salt. Not only are we facing the normal uncertainty with respect to economic and inflation developments. But when looking at the end of the year, i.e. the mid-December FOMC meeting, we need to incorporate the risk for a fiscal battle in Congress (and the specter for a government shutdown after December 8), and the potential impact of the devastating hurricanes. And then there is of course the increasing number of vacancies on the Fed Board. When Vice Chair Stan Fischer resigns next month, there will be only three people in the seven board seats – the smallest number of governors in the Fed’s history. And the future of Chair Yellen, whose term ends in February is not clear, either. As these vacancies are hopefully get filled during the next few weeks or months, views on the Committee may shift, and with it the FOMC’s median interest rate projections. But amid all these uncertainties, we stick to our call for another 25bp rate hike in December, followed by further normalization in 2018.
Today’s Fed announcement was in line with market expectations and today’s EUR/USD sell-off could be exaggerated. That is why a prompt recovery and come-back to bullish trend is likely.
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