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Economic Monitor – Weekly Commentary
by Scott J. Brown, Ph.D.

Fed policy: balance sheet normalization

September 25, 2017

As expected, the Federal Open Market Committee left the federal funds target range unchanged (at 1.00-1.25%) after its September 19-20 policy meeting. The FOMC also announced the beginning of balance sheet reduction. The Fed had outlined how this would work in mid-June, and officials did a good job of telegraphing when it would start. Investors were more surprised by the dot plot, which continued to show a majority of Fed officials anticipating one more rate hike by the end of the year.

The Fed’s three large-scale asset purchase programs (quantitative easing, or “QE”) added $3.4 trillion to the Fed’s balance sheet. The Fed is not planning on selling these securities. It will continue to reinvest maturing securities, but will allow a certain amount to run-off each month. The cap on the monthly run-off starts slow ($10 billion), but increases every three months, reaching full stride ($50 billion) in October 2018.

Monthly Caps on SOMA Securities Reductions

Treasury Securities

Agency Securities*

Oct – Dec 2017

$6 billion

$4 billion

Jan – Mar 2018

$12 billion

$8 billion

Apr – Jun 2018

$18 billion

$12 billion

Jul – Sep 2018

$24 billion

$16 billion

From Oct 2018**

$30 billion

$20 billion

*Applies to combined principal payments of agency debt and agency MBS. **Once caps reach their maximum amounts, they will remain in effect until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively. [Source: NY Fed]

In her post-FOMC press conference, Chair Janet Yellen said that the Fed does not plan on making adjustments to the balance sheet normalization program. The run-off is not “active” policy. The Fed will still rely on the federal funds target rate as “the primary means of adjusting the stance of monetary policy.” Still, the Fed could stop the program, or even purchase more securities if the economy were to experience a large negative shock (the federal funds rate would have to be dropped toward zero first). The Fed likely feared some adverse market reaction to balance sheet reduction, as we saw a few years ago with the taper tantrum. However, the Fed has signaled its plans well in advance and will start slow.

What does this mean for investors? Again, balance sheet reduction was well advertised. There’s nothing surprising in the announcement. All else equal, balance sheet reduction should mean a gradual increase in long-term interest rates, but there are a lot of factors driving bond yields (including inflation expectations and bond yields outside the U.S.). QE lowered the 10-year Treasury note yield by 50-100 basis points, so the unwinding would likely push yields up accordingly (all else equal). However, the size of the balance sheet is unlikely to fall back to where it was before the Fed’s asset purchases. The Fed will continue the run-off until the size of the balance sheet is “appropriate,” but it’s unclear what that means.

The revised dot plot (the expectations of senior Fed officials of the appropriate yearend level of the federal funds target rate) showed 11 of 16 officials expecting one more rate hike this year. Note that there is a lot of uncertainty surrounding each dot (Fed decisions will remain data-dependent) and not all of the dots represent voting members of the FOMC. Still, the December 2017 dots caught many market participants by surprise.

The dots showed a wide variation in policy expectations for 2018 and 2019, but the anticipated direction (higher) was nearly uniform. In the near term, much of the economic data will be distorted by hurricanes Harvey and Irma. Some of the important data (retail sales, manufacturing output) had suggested some sluggishness ahead of the storms. Yet, the availability of credit has continued to expand despite the increase in short-term interest rates in the first half of the year.


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