Fed balance sheet normalization at last

The U.S. Federal Open Market Committee (the Fed) held interest rates steady at Wednesday’s meeting, with a target range of 1% – 1.25%. After preparing the markets over the last several meetings, the Fed finally announced they would begin their long-awaited balance sheet reduction plans in October 2017.

The Fed will reinvest payments that exceed gradually rising caps with the initial cap of $6 billion per month on Treasuries and $4 billion per month for agency debentures and mortgage-backed securities combined. The caps will increase quarterly until they reach $30 billion per month for Treasuries and $20 billion per month for agency debentures and mortgage-backed securities. The reduction in future purchases by the Federal Reserve will require the market to digest a slightly larger supply of bonds each quarter, which could put pressure on interest rates to move higher.

The Fed’s statement did not contain many changes from the previous release in July, as the labor market was described as solid and household spending as expanding moderately. The Fed did acknowledge the devastation caused by recent hurricane activity, but it believes the storms are unlikely to alter the course of the U.S. economy over the medium term. It also recognized the temporary effect of higher prices from gasoline and other items after the storms, but continues to believe inflation will stabilize around the Committee’s 2% objective over the medium term. The Committee believes the near-term risks to the economy are roughly balanced and it will continue to monitor inflation closely.

The summary of economic projections was slightly more hawkish than anticipated, as the Fed’s dot plot saw minor changes but still reflects one remaining interest rate hike likely in 2017 and three hikes in 2018. The longer-term Federal Funds rate projections declined by 0.25% to 2.75%.

Because of the unchanged rate hikes for 2017 and 2018, the Fed’s announcement was somewhat more hawkish than the market anticipated and interest rates rose modestly after the statement was released.

At Invesco Fixed Income, we believe global growth should remain positive and the Fed’s announcement today does not change that in the near term. The environment should remain positive for stocks and bonds, but that may begin to change in the first half of 2018 as more central banks begin to shift to somewhat tighter monetary policy.