In my August 8 Forecasts & Trends E-Letter, I suggested that the Fed Open Market Committee (FOMC) may vote to begin the process of reducing the size of its massive $4.5 trillion balance sheet at its next policy meeting on September 19-20 – in lieu of hiking the Fed Funds rate a third time this year.
My thinking about a September balance sheet decision was based on new language the Fed added to its policy statement following the July 25-26 FOMC meeting. The new language said balance sheet reduction would likely begin “relatively soon.” I assumed that meant a vote at the September meeting.
The actual minutes from the July 25-26 FOMC meeting were released last week and included the specific language regarding the timing of the start of balance sheet reduction:
Participants generally agreed that, in light of their current assessment of economic conditions and the outlook, it was appropriate to signal the implementation of the [balance sheet reduction] program likely would begin relatively soon…
If I’m correct, the Fed will vote on September 20 to begin reducing its balance sheet by allowing $6 billion in Treasury securities and $4 billion of mortgage-backed securities to mature each month, most likely starting October 1. Eventually the monthly maturities will grow to $30 billion in Treasuries and $20 billion in mortgage securities.
Until just recently, most Fed-watchers had expected a third hike in the Fed Funds rate at the September FOMC meeting, with balance sheet reduction getting underway at the December policy meeting – or even sometime next year.
However, with the new “relatively soon” language regarding balance sheet reduction, it is not likely that the Fed would vote to begin trimming its balance sheet and hike the Fed Funds rate at the same meeting. The thinking now is that the FOMC will vote to reduce its balance sheet at the September meeting, and a third rate hike – if one comes at all before the end of this year – would happen at the December 12-13 meeting.
The growing question among Fed-watchers is whether or not the FOMC will raise the Fed Funds rate a third time this year. Based on the minutes from the July 25-26 policy meeting, it is clear that the members of the FOMC remain concerned that inflation continues to be well below their 2% target.
The Fed’s preferred indicator of inflation is the Personal Consumption Expenditures Index (PCE). According to this Index, US inflation rose only 1.4% (annual rate) in June, and is up only 1.5% over the last 12 months. As you can see below, the rate of inflation has been falling this year.
It is for this reason that more Fed-watchers think the FOMC may be reluctant to increase short-term rates a third time this year. As this is written, the Fed Funds futures market is giving only a 35% chance of a third rate hike in December.
Central Bankers Gather at Jackson Hole for Policy Meetings
The world’s top central bankers have gathered in Wyoming this week for their annual monetary and economic policy forum. On the one hand, the central bankers are relieved that the global economy has gotten stronger this year; on the other hand, they remain concerned that inflation remains inexplicably low – not only in the US but also in Europe and Japan.
There will no doubt be discussions about the so-called Phillips Curve which suggests that when labor market conditions are strong (as they are now), consumer prices historically move higher. Yet that’s just not happening this time around.
Fed Chair Janet Yellen will speak tomorrow morning, and she will almost certainly speak to the issue of the Fed reducing its balance sheet just ahead. There will also be discussions about the European Central Bank winding down its quantitative easing/bond-buying program later this year.
Last but not least, there will no doubt be many discussions about President Donald Trump in Jackson Hole this week – including his latest threat to shut down the government if he doesn’t get funding for the border wall. I think it’s safe to say Janet Yellen is not looking forward to those discussions!