As expected, the Fed left the Federal Funds rate unchanged at 1-1.25% and announced that it would begin the balance sheet normalisation program in October. The move to begin normalising the balance sheet was already outlined in June’s ‘Addendum to the Committee’s Policy Normalization Principles and Plans’. Between October and December the Fed will reduce its Treasury and Agency securities by USD6bn and USD4bn per month respectively and the caps will gradually rise over the next year to a maximum of USD30bn and USD20bn per month.
What sparked more interest from the market’s perspective was the updated economic forecasts and ‘dot plot’ as a rate hike is still on the cards for December and market implied probabilities of a Fed rate hike (in December) increased to ~64% at the US close and the US dollar traded stronger against the euro.
The median projection is for three 25 basis point rate hikes in 2018 with 6 participants (up from 5 in June) at the median of 2.125%. Interestingly, looking further out, the number of participants who forecast the longer-run policy rate below 3% rose to 9 out of 15 from 6 out of 15 in June. Moreover, 5 out of 15 now forecast the policy rate at or below 2.5%. While we see the forecast of a rate hike this year and 3 next year as aggressive the shift down in the longer term ‘dot plot’ projections is supportive of our preference to be positioned at the longer end of the curve.
The FOMC statement saw the recent hurricane impact as transitory noting ‘past experience suggests that the storms are unlikely to materially alter the course of the national economy over the medium term. Consequently, the Committee 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.’ The median GDP projection of the Committee’s participants edged a little higher to 2.4 percent for 2017 and remained unchanged at 2.1 percent in 2018. But their core PCE inflation estimates are slightly softer for this year and next at 1.6 percent and 1.9 percent respectively.
On the issue of inflation, Janet Yellen noted in her statement that ‘inflation has been running below the Committee’s 2 percent longer-run objective’ and that ‘our understanding of the forces driving inflation is imperfect, and in light of the unexpected lower inflation readings this year, the Committee is monitoring inflation developments closely.’ Nevertheless, she saw the weakness in inflation as transitory and that ‘this year’s shortfall in inflation primarily reflects developments that are largely unrelated to broader economic conditions. For example, one-off reductions earlier this year in certain categories of prices, such as wireless telephone services, are currently holding down inflation, but these effects should be transitory. Such developments are not uncommon and, as long as inflation expectations remain reasonably well anchored, are not of great concern from a policy perspective because their effects fade away.’
Overall, we expect that the inflation backdrop will remain benign and that US growth will remain subdued, and see downside risks to the ‘dot plot’ forecasts. If the Fed were to enact all of the forecast rate hikes and balance sheet normalisation, we would be concerned about increased risks of a recession. Our view remains that the Fed will remain ahead of the curve and the yield curve will flatten and we continue to favour positioning at the long end.