The FOMC completed their September meeting, with an outcome of no interest rate policy change as expected, but there was something a little different to announce. This was a more ‘important’ meeting, being one of the four per year that features a post-meeting press conference and Q&A session, used to clarify and fine-tune policy (which isn’t always crystal clear in the formal releases).
In the released statement, economic activity was described as having risen moderately this year, with solid job gains and low unemployment. Additionally, household spending shows moderate expansion with business capex having ‘picked up’ in recent quarters. Despite near-term challenges, the Fed noted that recent hurricanes are unlikely to alter the course of the broader national economy over the medium-term, aside from shorter-term inflation challenges from items such as gasoline.
The new item was the introduction of the balance sheet normalization program. What is that? As a backdrop, after the Fed completed the various rounds of quantitative easing years ago, where they had been actively buying treasury and agency mortgage bonds directly to keep yields low in those markets, they continued to reinvest proceeds of maturing bonds in order to keep stimulus from ‘trailing off’ too much, so to speak. The balance sheet is now $4.5 trillion in size, far larger than historical norms. To turn the stimulus faucet off completely and start reversing the build-up, it could require the significant selling of bonds held on its balance sheet, which could be disruptive to markets in large amounts by driving down prices and, hence, yields up. The other option—the one they’ve chosen to use—is letting maturities ‘roll off’ gradually by capping the amount of proceeds they’ll keep reinvesting.
This process is designed to not result in a large degree of market disruption—done by keeping the amounts limited and expectations for this normalization to be done over a long period of time, from $10 billion/month to start, and ramping this up over time. The assumption, based on statistics from the treasury and outside managers, is about 0.25-0.50% in upward yield drift ultimately. Today’s announcement was just the first step in a stimulus unwinding process, but it has to happen sometime. And, with the economy looking stronger, now is as good a time as any. Importantly, clearing space on the balance sheet could allow the Fed to again provide more stimulus down the road when we are faced with another slowdown, although, hopefully the amounts needed would be far less than during the years of the Great Recession, when stimulus spending was unprecedented.
The ‘dashboard’ of key data reflects few changes from recent meetings:
Economic growth: GDP growth picked up in Q2 to a greater degree than anticipated, and a similar pattern was originally expected for Q3 as well, until the impact of the multiple hurricanes in the Southern U.S. lowered hopes. These disasters could shave up to a percent off of GDP growth in the near-term, with the mixed blessing of a likely positive impact on growth 1-3 quarters in the future due to intensive rebuilding efforts.
Inflation: After running low for several months straight, CPI picked up a bit for August to +1.9% on a headline basis and +1.7% for core on a year-over-year basis. This is still below the Fed’s mandate, and appears to be due to a usual stew of conflicting internal influences, but there do not appear to be severe inflation trends at play to a large degree. This continues to challenge central bankers looking for inflation as a reason to proceed with further tightening.
Employment: The unemployment rate and jobless claims continue to run at very strong/low trend levels, in keeping with broad labor strength. This environment is also reinforced by JOLTs data and, to a more sporadic degree, by nonfarm payrolls. While further extreme improvement appears more difficult to come by as the ‘easy’ gains have already been made, the strength of this criteria does push the Fed toward tightening.
Probabilities have decreased for another rate hike before the end of the year (likely in December), from about 50/50 to a bit below that. Naturally, data over the next few months will dictate how accurate those odds become, but the tempered pace set from the get-go by the Fed looks to continue in the world of slower growth and inflation pressures. This pace has implications for asset markets. Lower rates have the tendency to push asset prices higher, as well as keep borrowing costs depressed, which can be a positive for investors (not savers so much), assuming they don’t stay so low and/or accommodation for so long that bubbles are created. The muddle-through economy appears to be persistent as questions now turn to whether we’re in the mid- to late- portion of the economic cycle.