— When Fifth Rate Hike And Balance Sheet Reduction Comes Less Certain
— Yellen Comments Key As Market Awaits Two-Path Policy Clues
By Steven K. Beckner
Written exclusively for InTouch Capital Markets
9th June 2017
Though not absolutely certain, the Federal Reserve seems highly likely to raise short-term interest rates again at the conclusion of its June 13-14 Federal Open Market Committee meeting.
Financial markets will be astonished if the FOMC does not take the federal funds rate up another quarter percentage point notch for the second time this year — the fourth since leaving the zero lower bound in December 2015.
[See the below table for InTouch Capital Markets latest analysis of what’s priced into the market for FOMC rate hikes at coming meetings. Markets currently see an 89% chance of a hike next week (based on OIS markets)]
With the FOMC presumably increasing the funds rate target range to 1% to 1.25%, the Fed Board of Governors, the Committee’s core, will almost automatically raise the interest rate on excess reserves (IOER) by 25 basis points to 1.25% and push the primary credit discount rate a like amount to 1.75%.
To help set a floor under the higher funds rate, the New York Fed’s open market trading desk will undoubtedly be directed to make overnight reverse repurchase agreements available at 1.00% to a wide array of counterparties, including those not eligible to earn IOER.
The FOMC also seems likely to make further incremental progress toward tightening financial conditions on the long end of the yield curve as it continues its inexorable march toward reducing the Fed’s $4.5 trillion balance sheet. Some think it could go even further, though just how fast the FOMC wants to proceed down that path is unsure.
Unwinding the balance sheet is much the trickier of the two monetary policy facets and will require ample signaling.
Fed officials are big believers in the efficacy — and necessity — of clear communication, and the mid-year meeting will provide a sterling opportunity. In addition to the Wednesday afternoon policy statement and possible addendums, the FOMC will publish a revised set of economic and funds rate projections, and of course Chair Janet Yellen will hold her quarterly press conference.
Expectations for a June 14 rate hike were justifiably cemented in market players’ minds by minutes of the May 2-3 FOMC meeting, which disclosed, “most participants judged that if economic information came in about in line with their expectations, it would soon be appropriate for the Committee to take another step in removing some policy accommodation.”
Policymakers also strategized anew on trimming the balance sheet, the minutes show: “Nearly all policymakers indicated that as long as the economy and the path of the federal funds rate evolved as currently expected, it likely would be appropriate to begin reducing the Federal Reserve’s securities holdings this year.”
They outlined a basic strategy for scaling back the reinvestment of proceeds from maturing securities.
Since then, most economic data have validated officials’ assessment that first quarter GDP weakness was “transitory.” And their statements have largely reinforced the notion a June rate hike is needed.
Fed officials have made a seemingly coordinated effort to let financial markets know more monetary tightening is coming in the form of higher short-term interest rates on the near horizon and, later, higher long term rates through reversal of quantitative easing.
For the most part they’ve been singing from the same sheet music, the common theme being: here’s what’s coming, but have no fear. We won’t shock you.
Thus, San Francisco Federal Reserve Bank President and former top Yellen advisor John Williams, on May 29, said, “As it stands today, interest rates remain near historical lows…Gradually raising interest rates to bring monetary policy back to normal prevents our economy from overheating and thereby reduces the risk of a future economic correction.”
A day later, Fed Governor Lael Brainard, once considered the most dovish FOMC member, declared that “with continued strength in the labor market, economic activity regaining momentum, and a brighter outlook abroad, it would be appropriate soon to see the federal funds rate moving closer to its neutral level.”
On June 1, Governor Jerome Powell chimed in: “The healthy state of our economy and favorable outlook suggest that the FOMC should continue the process of normalizing monetary policy….If the economy performs about as expected, I would view it as appropriate to continue to gradually raise rates.”
The mainstream Powell also deemed it “appropriate to begin the process of reducing the size of the balance sheet later this year.”
True, the May job data proved softer than expected, but it is highly doubtful policymakers are seriously worried about that. Even on the heels of that June 2 report, they kept looking toward higher rates.
Philadelphia Fed President Patrick Harker noted the slower than projected 138,000 rise in non-farm payrolls, but nevertheless said, “Based on the strong economic outlook, I continue to see three rate hikes for 2017 as appropriate.”
The payroll data aren’t viewed in isolation at the Fed. Although they fell short of expectations and April payrolls were revised down, the average monthly gains of 121,000 for the last three months is well in excess of the minimum officials believe needed to absorb new entrants into the labor force. Besides, they believe, slowing of payroll growth is inevitable as labor utilization increases.
As FOMC voter Harker observed, “we won’t need the same rate (of payroll growth) going forward. Estimates vary, but somewhere between 70,000 and 100,000 a month is what many believe is appropriate to keep up with population growth.”
The unemployment rate’s drop to a 16-year low 4.3% was due in large part to a dip in labor force participation to 62.7%, but there is evidence labor markets are tightening. Job openings and quits are up, and the latest beige book survey found “most Districts citing shortages across a broadening range of occupations and regions.”
“Ultimately, we’re looking at a labor market with very little slack left,” said Harker, echoing a common view.
Admittedly, officials would like to see wages rising more rapidly, just as they’d prefer a faster price increases. Average hourly earnings rose a disappointing 0.2%, leaving them up 2.5% from a year ago.
However, broad measures of labor compensation have improved and are expected to improve further.
Then too, payrolls are notoriously subject to revision — perhaps more than usual this time owing to survey date quirks, which are believed to have depressed jobs and wages.
Other indicators have been more encouraging. The Institute for Supply Management’s purchasing manager surveys show a hiring pick-up in manufacturing and non-manufacturing industries.
Fed officials would like to see more progress toward their symmetrical 2% inflation target, but have confidently predicted that will be achieved “over the medium term.”
Powell acknowledged “inflation has run below 2% for most of the period since the financial crisis,” but said, “over the past two years, inflation has moved gradually closer to our objective….”
“Some of the recent weakness can be explained by transitory factors,” he continued. “And there are good reasons to expect that inflation will resume its gradual rise.”
So neither side of the Fed’s domestic “dual mandate” obstructs higher rates. Private and public comments reveal a determination to get on with monetary normalization that won’t easily be deterred.
Facilitating both facets of normalization is an improved global economy. In contrast to recent years when “financial and international developments” inhibited rate hikes, the European economy is outperforming the U.S., and the World Bank projects the fastest global growth pace in seven years.
After a first quarter in which U.S. real GDP grew a meager 1.2%, second quarter is projected by the Atlanta Fed at 3.4%.
We’ll see how much FOMC participants change their own GDP, unemployment and inflation forecasts — and in turn their funds rate “dots” — in the revised Summary of Economic Projections next Wednesday. Large revisions seem unlikely, but that alone would send a message.
Even more important will be what Yellen tells reporters — in her opening statement and in response to questions.
For while a rate hike next week seems sure, it is less certain how policy will evolve beyond June. Assuming the FOMC does raise the funds rate, will the third rate hike (to 1.25-1.50%), which the FOMC projected in March, come in September or December? And when will balance sheet reduction begin?
Yellen can, if she and her colleagues wish, give strong indications about the timing of further rate hikes and the commencement of balance sheet reduction.
Futures market odds are weighted toward the subsequent rate hike coming in December. But it’s not obvious why the FOMC would wait that long, or why they would want to begin balance sheet reduction before making that third hike — the fifth since the Fed left the zero lower bound.
It has been speculated the third rate hike will be deferred because of concern about potential market disruption due to Congressional brinksmanship over the debt limit. But while it’s possible the third rate hike will be delayed, that would more likely result from dimming prospects for fiscal stimulus or changed perceptions of the economic outlook than from debt limit hijinks.
Whether it raises rates in September or puts it off, the FOMC could argue normalization of the funds rate is “well under way” — the guidance for curtailing reinvestments it has given since “lift-off” a year and a half ago.
Judging from the prominence it was given in the May minutes and in officials’ comments, it’s possible the FOMC will aim for an earlier launch of balance sheet reduction, which might entail setting caps on reinvestments as early as September instead of waiting for December.
With the 10-year Treasury yield barely over 2 1/8%, the Fed might deem this an opportune time to start scaling back reinvestments.
If that’s the chosen course, the FOMC could conceivably announce changes to the Policy Normalization Principles and Plans first published in September 2014 as early as next week.
The May minutes revealed “policymakers agreed” those principles and plans “should be augmented soon to provide additional details about the operational plan to reduce the Federal Reserve’s securities holdings over time.”
We must watch for a supplemental announcement next Wednesday. Failing that we’ll need to parse Yellen’s remarks for clues as to when it might come.
My hunch is the FOMC will wait a while to give maximum time for market preparation. There are those who want to speed up the process of shrinking the balance sheet, but my sense is most officials want to move expeditiously, but not hurriedly.
Williams says “the process will begin when we’re further along the path of normalizing the level of the federal funds rate. Based on my forecast, this will occur sometime later this year.” That’s a fair reflection of the current consensus.
The majority is focused on keeping the funds rate the primary policy tool and building a cushion relative to the zero lower bound.
Policymakers have been vocal about how “boring” the process of shrinking the Fed’s bond portfolio will be, but I suspect there are elements of whistling past the graveyard and preventive incantation in such talk. They are ever mindful of the “taper tantrum” that spiked bond yields when former Fed Chairman Ben Bernanke’s merely hinted at reduced asset purchases in 2013. They don’t want a repeat.
When Williams advertises “the most telegraphed monetary policy of our lifetimes,” when Chicago Fed President Charles Evans, Harker and others talk about making balance sheet reduction “boring,” when Brainard talks about putting it “on autopilot,” I sense a desire to take time to lay the groundwork to make absolutely sure another “tantrum” isn’t triggered.
The FOMC majority wants to get to the point where it can continue to gradually push up the funds rate toward the putative “neutral” 3% while balance sheet shrinks “in the background,” as Williams puts it.
But before the Fed gets to that point it wants a pretty good idea about the impact of reduced reinvestments on yields and about the interaction of funds rate hikes and allowing maturing securities to run off.
Calculations are being made by Fed economists. A recent research paper by Federal Reserve Board staff cited by Powell estimates unconventional policies are holding down term premiums by about 100 basis points, but surmises these effects will dip to about 85 basis points by the end of 2017 “as market participants see the normalization process approaching.”
“The same approach suggests that bringing forward the date of the start of the anticipated phasing out of the Federal Reserve’s reinvestments from mid-2018 to the end of 2017 should have raised the term premium by only about 5 basis points,” Powell said. Brainard estimates the rate impact of balance sheet reduction at 90 basis points.
But the interaction of the two tools is difficult to calibrate. Brainard notes, “there may be differences in the specific ways changes in short-term rates and the balance sheet transmit to different asset prices and the exchange rate, although estimates are limited and lack precision.”
Also militating against an early start to balance sheet reduction, perhaps, is that the end game — what size balance sheet the Fed wants to get to and under what policy implementation regime — remains unresolved. That will dictate the balance sheet’s ultimate size and the pace at which it is reached.
There is general recognition the balance sheet can’t return to its pre-crisis level of $900 billion — if only because currency in circulation alone has swollen to $1.5 trillion. Treasury cash balances and other liabilities add another $600 billion.
Some officials would like to retain a system of large reserves buttressed by the IOER and ON RRP, out of a desire to facilitate the use of unconventional policies, on the presumption that a lower equilibrium rate makes it more likely the Fed will return to the zero lower bound and have to resort again to quantitative easing.
Folks at the New York Fed, who once had mastery of hitting a funds rate target under scarce reserves, have become quite comfortable using the IOER and ON RRPs to set a floor under the funds rate.
But there are drawbacks, not the least of which the politically unappetizing need to pay ever larger interest payments on reserves, including to foreign banks.
If short-term rates went back to zero and there were limits to how much the Fed could balloon its balance sheet, the Fed could take a cue from other central banks and resort to negative interest rates, maybe even abolish cash to thwart depositor efforts to escape negative rates. But that has even bigger political problems.
Other officials long for a return to relatively scarce reserves and traditional open market operations to target the funds rate.
We’ll likely end up somewhere in between — with a balance sheet considerably smaller than now but much larger than pre-crisis.
Once the Fed gets going on unwinding its massive portfolio, the process may indeed be predictable and, yes, “boring.” But all of the above would seem to bespeak caution about making a start.
Just how cautious is what we hope to learn from Yellen.
Prior article by Steven Beckner for InTouch Capital Markets: FOMC Took Big Step Toward Shrinking Balance Sheet In May, Minutes Show
Steven Beckner is a veteran financial journalist with four decades of experience of reporting on the Federal Reserve. Mr Beckner is also the author of Back From The Brink: The Greenspan Years (Wiley, 1997) and can also be heard speaking regularly for National Public Radio.