Neutral Rates, Neutral Balance Sheet

As widely expected, the Federal Reserve held interest rates steady at this week’s FOMC (Federal Open Market Committee) meeting, but other aspects of the meeting had notable implications for markets and investors.

As widely expected, the Federal Reserve held interest rates steady at this week’s FOMC (Federal Open Market Committee) meeting, but other aspects of the meeting had notable implications for markets and investors.

First, large revisions to the policy rate path outlook confirmed that a strong majority of Fed officials no longer sees the need for restrictive monetary policy, and they now see a prolonged period of rates at or slightly under their estimate for neutral. (As recently as the December FOMC meeting, members expected interest rates to rise to around 50 basis points (bps) above neutral.) And second, the Fed released a plan to begin slowly reinvesting its maturing U.S. Treasury and mortgage-backed securities (MBS) holdings, which confirmed that the balance sheet will remain appreciably larger than its pre-crisis size.

Overall, we believe Wednesday’s announcements support our view that U.S. monetary policy, as set by both interest rates and the Fed balance sheet, is at or very close to neutral. And amid moderate inflationary pressures, manageable financial stability risks, and a more uncertain outlook, the Fed’s more cautious approach could ultimately support a sustained expansion.

Fed: Restrictive monetary policy is no longer warranted

In the Fed’s new Summary of Economic Projections (SEP), the distribution of participants’ 2019 year-end fed funds rate expectations was revised materially lower versus the previous SEP in December, with 11 of the 17 FOMC members now expecting rates to remain unchanged through 2019, and seven expecting unchanged rates through 2020. Importantly, these revisions reduced the median rate expectation by 50 bps in 2019, 2020, and 2021. The last time that the current year’s median “dot” fell 50 bps was in March 2016, after the Fed had hiked rates for the first time in December 2015 and fears of an economic “hard landing” in China were reverberating through markets.

Similarly, the risk today that slower Chinese and European growth will spill over into other economies has increased the uncertainty around the U.S. outlook. Furthermore, economic data received since the December and January FOMC meetings have shown a clear moderation in the pace of U.S. growth. And while still not signaling an imminent recession, in our view, the recent run of economic data argue for some downside risks to our long-standing below-consensus forecast for U.S. annual average growth to slow to the 2%–2.5% range in 2019. Indeed, an accelerated pace of inventory accumulations last year along with the meaningful decline in economy-wide sales growth since November raise the risk that production slows more meaningfully over the next one to two quarters to correct inventory levels.

Fed balance sheet to remain large, but it’s still a policy tool

Consistent with the monetary policy message emanating from the rate path forecasts, the Fed released a plan for ending the current balance sheet reduction program, signaling that it believes it is close to reaching a more neutral (“normalized”) balance sheet size after many years of extraordinary accommodation.

The Fed announced it will end asset redemptions in September, when reserve levels are around $1.5 trillion, after tapering the pace of reserve drains in May. After that, the Fed will allow reserves to decline further with growth in currency in circulation and the Treasury’s General Account (TGA) to reach a level between $1.3 trillion and $1.4 trillion by mid-2020.

We estimate that the minimum level of reserves demanded by the financial system is approximately $1 trillion, and that a buffer of between $300 billion and $400 billion is appropriate for effective implementation of monetary policy and to mitigate the risk of unexpected bouts of volatility in money markets.

Given the intrinsic uncertainty around these estimates, we think the Fed is right to slow the pace of decline by “tapering” asset redemption while reserve levels are still abundant. This will give the Fed time to react in the event the reserves become scarce sooner than expected.

Notably, no decisions were announced on the long-run weighted average maturity of the Fed’s Treasury holdings. The Fed has been clear that it prefers U.S. Treasuries to MBS, and it will begin to reinvest MBS maturities into Treasuries starting in September. However, the FOMC has not made a decision on the optimal composition of Treasury securities. Eventually, we think the Fed will announce that it will reinvest and grow the balance sheet by matching the maturity of the Treasury market. This will ensure consistency across the policy tools in the event that the Fed’s (and our) outlook for a stable policy rate is realized.

Bottom line: U.S. economic growth has slowed from a breakneck pace earlier in 2018, and the downside risks have increased, negating the need for restrictive monetary policy. Appropriately, FOMC officials have responded to this new information by adjusting their outlook. In many ways, Wednesday’s meeting confirmed previous communications that the Fed is committed to a balanced risk management strategy, which supports sustained growth.

Read our latest Cyclical Outlook, “Flatlining at The New Neutral,” for insights into global growth, trends, and uncertainties, along with investment implications.

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Tiffany Wilding

North American Economist

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September Fed Meeting: Divisions Over the Path of Policy
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