Say goodbye to the easy money policy that the Federal Reserve has pursued since the dawn of the financial crisis. The Central Bank, in a historic move, said today that beginning next month it will take a slow and easy route to unwind the lofty balance sheet it has accumulated these last nine years.
At the same time, the Federal Open Market Committee (FOMC) left interest rates untouched at 1% to 1.25%. The CME FedWatch tool, a predictive measure of Fed funds futures, all but guaranteed that would happen with its near 99% probability call of a nonevent.
“In view of realized and expected labor market conditions and inflation, the committee decided to maintain the target range for the federal funds rate,” the statement reads, reiterating material in the last three statements.
When will the Fed raise rates again? Hard to tell, as the Fed is good at hinting about what might lie ahead but has tended not to broadcast outright what direction it will take. Wall Street appears to be banking on December, which the Fed seemed to imply was a possibility in the notes. If that happens, the Fed will have upped rates three times this year, which 12 of the 16 Fed members believe is still likely, according to the Fed notes.
At a press conference after the announcement, Chair Janet Yellen noted “economic growth will be held down by the severe” weather disruptions, but not take it off its ultimate path.
“Hurricanes Harvey, Irma, and Maria have devastated many communities, inflicting severe hardship,” the statement says. “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.”
Consequently, the Fed continues to expect that, with “gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, and labor market conditions will strengthen somewhat further.”
But it continues to believe that “economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate,” adding yet again that “the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.” However, Yellen mentioned a number of times during the press conference that “nothing is set in stone.”
Still rankling the Fed is the slow-but-picking-up-steam economic growth that appears to be keeping inflation at bay. Though inflation has remained stubbornly below the Fed’s 2% target for some time, it appears the Fed is now adjusting its outlook to the lower measure, an acquiescence that it acknowledged at its July meeting.
“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% in the near term but to stabilize around the committee’s 2% over the medium term,” the Fed reiterated again today. What’s new to the statement is that the committee is “monitoring inflation developments closely.”
During the press conference Yellen said the Fed isn’t exactly sure why inflation is staying low, but added, “We do have a commitment to raising inflation to 2%. We will look at incoming data on inflation and other economic variables…in deciding what we should do. If the shortfall is persistent, it will be necessary to address monetary policy.”
History, she said, has shown that a tight labor market tends to push up wage and price inflation, but also risk. The Fed needs “to be careful not to allow the economy to overheat” because it might “force us to tighten monetary policy rapidly, which could cause a recession and threaten” economic growth, she said.
As for unraveling the $4.5 billion package of Treasury and mortgage-backed securities that were used to prop the economy during the depths of the recession, the Fed noted that it would “initiate the balance sheet normalization program,” in October, according to the statement. (See below.)
The Fed’s next two-day meet is slated for Oct. 31-Nov. 1, and it does not include plans for a press conference. The Fed has tended to shy away from raising rates when there isn’t a press conference afterward to discuss the move and the economy. To that end, the FedWatch tool sees only a 2% probability of a hike in November, dropping a full percentage point from before the announcement.
December looks to be a different story, with odds standing at nearly 71%, jumping from 56% before the meeting. That’s double the 35% range the measure was projecting a little more than a week ago. By December, the Fed will have seen a bevy of economic reports, including two jobs reports and possibly some movement in Congress on economic and tax issues, to deconstruct for more guidance.
Meanwhile, the Markets Were….
As what tends to typically happen ahead of a Fed decision, the markets were mostly muted. The Dow Jones Industrials ($DJI) and the S&P (SPX) were marginally higher in the hour leading up to the announcement, while the Nasdaq (COMP) was edging lower. All three turned sharply lower immediately after the announcement, but appeared to lighten up as Yellen spoke with the $DJI tipping in and out of positive territory and the SPX flattening before both ending to the upside. All three benchmarks have been nudging into fresh record highs in recent sessions, and going into the announcement, $DJI was on track to chart a ninth straight day of gains while the SPX was roaming around in record terrain.
Treasury yields, which run opposite of bond prices, have been inching up in recent sessions but the widely-watch 10-year note was flat at 2.241% ahead of the announcement. Afterward, it climbed to 2.285% (See chart.)
FIGURE 1: WILL 10-YEAR YIELDS RISE? The yield on the 10-year Treasury note, plotted here Wednesday on the TD Ameritrade thinkorswim® platform, has been edging higher ahead of the Fed decision. Some analysts think shrinking the balance sheet might push yields up by next year. Data source: CME. For illustrative purposes only. Past performance does not guarantee future results.
How Might the Fed Unwind: To put this into perspective, first remember that this is history in the making, there is no template or “past experience” for this effort to prune a dense collection of bond holdings. Why? Mostly because the balance sheet, at $4.5 trillion, has never been this large. (When the Fed started this, the balance sheet stood at $900 billion.) Some Wall Street analysts have pointed out that it’s unclear how the economy and the stock market might react when that much money is taken out.
But don’t forget how the Federal Reserve pumped those funds into the economy. The Federal Reserve did not use cash—what private investors tender to purchase bonds—to build up its reserve. Remember that the Fed “controls” the money supply.
The Fed has said it will shrink the balance sheet by allowing small amounts of Treasuries and mortgage-backed securities to mature without reinvesting them, which is considered a passive move. Because there was no actual cash involved, the Liberty Street Economics blog (written by New York Fed members) explains, a Treasury security, for example, gets logged as a liability on the Fed account, and money is credited to the bond seller. Yes, the Fed pulls that “money” out of thin air. It has that ability under law. So, when the bonds mature, the liability is erased.
“It won’t be destroying any paper currency, but the money essentially vanishes from the financial system,” according to the Wall Street Journal. That’s how the Fed was able to juice the economy with more “money,” and is probably why some worry that taking that “money” out of the financial system has the potential to be harmful to the economy. Stay tuned.
How Slow is Slow and Deliberate? Think of this as a diet.
This stop-the-reinvestments plan was outlined in June, starting with a “small” rollout of $10 billion of assets a month that ramps up slowly. The plan indicated that it will start with letting $6 billion of Treasury securities and $4 billion of mortgage-backed securities mature. The Fed said that is expected to climb to $50 billion a month and as much as $600 billion a year.
Remember that these actions are considered another form of economic tightening.
How They Voted: After every FOMC meeting, Wall Street seems to have intense interest in how the vote came out. Unanimous assent tends to be seen as a positive sign, particularly when a still precarious economy hangs in the balance.
At this meeting, the vote was unanimous.
Add that to this year’s scorecard: July and May meetings were unanimous while March’s meeting featured Minneapolis Fed president Neel Kashkari as the lone dissenter when rates were raised then.
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