As expected, the Federal Open Market Committee (FOMC) kept its target for the federal funds rate unchanged at 1.00%-1.25% and announced that it will begin reducing the size of its balance sheet in October.
The decision on interest rate was unanimous and widely anticipated despite an uptick in consumer price inflation last month. While the Federal Reserve acknowledged the effects of hurricanes Harvey, Irma, and Maria, noting that it expects slower economic growth and higher inflation in the near term, its 2017 and 2018 core personal consumption expenditure (PCE) inflation median projections were revised down to 1.5% and 1.9%, respectively, before stabilizing around the 2% target.
S&P Global still expects the slow pace of underlying inflation to keep the Fed from raising rates again this year and look for three rate hikes next year.
In contrast, the Fed's so-called "dot plot" of interest rate projections still points to another rate hike this year. The consensus on the FOMC continues to view that slowing in the pace of inflation is due to temporary reasons. In her remarks, Fed Chairwoman Janet Yellen reiterated her view that the softness of inflation figures this year is likely to be transitory and doesn't reflect broader economic trends. However, she also suggested that the Fed's understanding of the underlying forces driving recent inflation trends is "imperfect."
Overall, the FOMC forecast revisions were more or less unchanged from those made in the June meeting. The Fed presented a cautious but positive view of the U.S. economy, highlighting solid job gains and increases in both household spending as well as business fixed investment in recent months. The FOMC members' median GDP growth forecast for this year is 2.4% (up from 2.2% in June) and 2.1% for 2018 (unchanged from June). The median forecasts for PCE inflation (1.6%) and the unemployment rate (4.3%) remained unchanged for 2017 as well as over the long term. The long-term neutral rate forecast for the federal funds rate was cut to 2.8% (versus 3% in the June projection).
The Roll-Off Road Map
Despite the uncertainty surrounding its interest rate policy, the Fed definitively announced that it will begin unwinding its $4.5 trillion balance sheet starting in October 2017. Most of the details specified by the Fed are in line with those outlined in the Addendum to the Policy Normalization Principles and Plans (issued after the June 2017 FOMC meeting).
The Fed's normalization policy is built around two pillars:
- Securities are allowed to mature or be paid down without reinvestment, subject to a series of increasing caps; and
- The portfolio is unwound in a measured and predictable pace until reserve balances reach a level that will "reflect the banking system's demand for reserve balances and the [FOMC's] decisions about how to implement monetary policy most efficiently and effectively in the future."
Specifically, starting October 2017, the Fed will allow a gradual roll-off of its System Open Market Account (SOMA) portfolio by initially reducing its holdings of Treasury securities by $6 billion per month and its holdings of mortgage-backed securities (MBS) by $4 billion per month. The caps increase every quarter by $6 billion and $4 billion (for Treasury and MBS, respectively) until reaching a monthly ceiling of $30 billion and $20 billion. Any payments of principal received in excess of these caps will be reinvested, but if the amount of run-off from maturing securities happens to be less than the cap, the Fed will not sell securities to make up the difference.
Based on the schedule of SOMA Treasury maturities and MBS pay-downs forecasted by the Federal Reserve Bank of New York in their July 2017 report, we project that once the normalization process starts, the Fed's holdings of Treasuries and MBS will shrink gradually until mid-2021 (see chart 3). After the so called "steady-state" level of reserves has been reached, the Fed will have to start increasing the size of its balance sheet to keep up with the growth of currency in circulation (which we have assumed to be in line with our projection for money supply growth). For the purposes of this projection, we have assumed a steady-state reserve level of $600 billion. (While we have based our analysis on the Fed's estimates, it is worth noting that it is especially difficult to forecast principal pay-downs associated with MBS, since levels depend on factors such as interest rates, housing prices, and credit conditions, all of which are subject to change over the projection path.)
Of course, despite the guidance provided by the Fed, the ultimate size of the Federal Reserve's balance sheet will depend on a number of structural factors and policy decisions that have yet to be made. Much depends on what the Fed decides is the optimal level of reserve balance for conducting monetary policy. However, other than indicating that the level of reserves will be larger than pre-crisis levels, the Fed has provided no direction about its ultimate objective with respect to the size of its balance sheet. As it gets ready to initiate unwinding of its balance sheet, the Fed has once again entered unchartered territory, the implications of which will not be fully seen for a while.
We expect that the combination of the gradual normalization of both policy rates and the balance sheet will slowly lift long-term interest rates higher over the next few years, but toward a much lower ceiling than what has been observed historically.