It’s Official – Balance Sheet Normalization Begins in October

It’s Official – Balance Sheet Normalization Begins in October




by Ryan Detrick, LPL Research

As was expected, the Federal Reserve’s (Fed) policymaking arm, the Federal Open Market Committee (FOMC), passed on a rate hike but did announce that its balance sheet normalization program, first discussed in an addendum to the June FOMC meeting statement, will begin in October.

The plan calls for the gradual reduction of the Fed balance sheet by decreasing reinvestment of principal payments from maturing bonds. The Fed will start slow, with an initial cap of $10 billion per month ($6 billion for Treasuries and $4 billion for mortgage-backed securities), which will increase by $10 billion every three months until reaching a maximum of $50 billion. We continue to believe that the initial impact to markets will be limited as market participants have had plenty of time to price in this well telegraphed move.

Changes to FOMC members’ expectations for the path of rate hikes in the near future were limited. The median expectation continues to be one more hike in 2017 (likely in December), and three more in 2018. However, the Fed did reduce the number of hikes they expect in 2019 from three to two, and also added a projection for 2020, where the median expectation is one rate hike.

The Fed’s statement described household spending as expanding at a moderate rate, while business fixed investment was described as picking up in recent quarters (click here for a side-by-side comparison of today’s statement versus the Fed’s statement released at the last FOMC meeting on July 26, 2017). Below-target inflation had been a hot topic during recent Fed meetings, and last week’s stronger than expected August Consumer Price Index (CPI) report led to optimism on the part of some market participants that inflation could be picking up.

While the Fed statement didn’t specifically mention the CPI report, it did indicate that the Fed expected a temporary bump in inflation due to the impact of recent hurricanes, but expects additional near-term weakness before inflation stabilizes around its 2% target in the medium term. In addition, the FOMC mentioned that the disruption from the hurricanes and rebuilding efforts may have an impact on near-term economic data, but isn’t likely to have a lasting effect on the trajectory of the economy. As it has done in the past several statements, the FOMC highlighted that the “near-term risks to the economy are roughly balanced,” and noted that the committee was “monitoring inflation developments closely.”

Stocks were down slightly in the immediate aftermath of the decision before recovering to end the day, while bond yields moved higher. This reaction makes some sense given the somewhat hawkish tone by the Fed as it stuck to its guns on three rate hikes in 2018, even as it downgraded its inflation forecast slightly. However, we will continue to monitor sentiment as initial reactions often change as market participants have more time to digest the Fed’s guidance.

Fed Chair Janet Yellen was holding her post-FOMC meeting press conference as this blog was being prepared.

 

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The Federal Open Market Committee (FOMC) is the branch of the Federal Reserve Board that determines the direction of monetary policy. The eleven-person FOMC is composed of the seven-member board of governors, and the five Federal Reserve Bank presidents. The president of the Federal Reserve Bank of New York serves continuously, while the presidents of the other regional Federal Reserve Banks rotate their service in one-year terms.
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