Fed Watch: A 'gradual and predictable' unwind begins

09-20-2017

As expected, the Federal Reserve announced that the gradual reduction in its $4.5 trillion balance sheet will begin in October through the tapering of reinvestment of maturing securities. This change represents the next iteration in a long, gradual path towards normalizing monetary policy. The Fed’s intention to shrink its balance sheet and its method for doing so were clearly telegraphed in prior Federal Open Market Committee (FOMC) communications. As if to emphasize that this historic step should not prompt a sharp market reaction, the FOMC relegated its announcement to the very end of its post-meeting statement.

The FOMC held current policy rates unchanged in a range of 1-1.25%, but provided some new insights into the expected trajectory of policy rates in the “dot plot.” Notably, 11 of 16 FOMC participants reaffirmed one additional expected tightening in 2017, a bit of a surprise to the market which had come to view the likelihood of such tightening as, at best, a coin flip. The median projected fed funds rate for year-end 2018 remained unchanged at 2.125%, but declined by one hike for year-end 2019 and for the long-run level, which is now 2.75%. Projections for GDP growth moved up only slightly, with upward revision for 2017 to 2.4% from 2.2%. Inflation projections for 2017 and 2018, however, edged lower, with both the median projection for headline and core PCE now remaining below the Fed’s 2% target level in 2017 and 2018. The policy dots clearly indicate most FOMC members anticipate the economy will hit 2% inflation in 2019, while lower implied inflation rates and short-term rates from various market instruments express significant doubt.

The statement also acknowledged inflation has fallen this year, repeated that policymakers will be monitoring it closely and expressed confidence inflation should rise over the “medium term.” The statement characterized growth as moderate, with solid job gains, low unemployment, modest growth in consumer spending and some acceleration in business investment. The Fed also specifically mentioned economic dislocation from the recent hurricanes, acknowledging likely near-term impacts, but expecting no medium term impacts.

Following the FOMC statement and Chair Janet Yellen’s press conference, Treasury yields generally rose and the yield curve flattened. This reaction reflected upward revisions in the prospects of a December tightening and the Fed’s reaffirmation of three expected hikes in 2018 amid below-target inflation. With so many vacancies emerging on the Board of Governors, including the Vice Chair and likely the Chair, the market seems to take 2018 and longer run projections with a large grain of salt, remaining focused on whether or not inflation will comply with Fed expectations or with those of the market.