Economy

FOMC Watch: Why Fed's Balance Sheet Language Will Trump Interest Rate Hikes

Jon C. Ogg

Published: June 9, 2017 11:50 am

Last Updated: January 12, 2020 11:11 am

Global financial markets, economists and consumers alike are all about to get a fresh diagnosis on the growth expectations of the economy. The Federal Open Market Committee (FOMC) of the U.S. Federal Reserve will begin a two-day meeting on Tuesday, June 13. The official decision will be announced through major media outlets at roughly 2:00 p.m. Eastern Time on Wednesday, June 14.

The view of 24/7 Wall St. is that investors and economic watchers need to pay more attention to commentary and implications of the Fed’s balance sheet rather than the formal rate hike announcement. As of May 29, 2017, the Fed’s balance sheet was a whopping $4.459 trillion. Some Fed presidents and governors have been more open in recent weeks and months about the idea of ratcheting down at least some aspects of the Fed’s balance sheet, but the devil in the details should be what calms or spooks Wall Street and Main Street alike.

It is already widely expected that there will be a FOMC rate hike on federal funds at the June meeting, with all forecasters looking for a 0.25% hike to the range. The FOMC will also release its near-term and longer-term forecasts, and then at 2:30 Federal Reserve Chair Janet Yellen will have a press conference where she rereads the news and then takes questions and answers.

The CME’s 30-day fed funds interest rate future is now priced at $98.965, which suggests more than a 100% chance that the target rate will move to above 1.00% from the current 0.75% to 1.00% range.

What is now up for grabs is just how aggressive the FOMC will be on rate hikes after June. It earlier had been expected that one or two more rate hikes in fed funds would come after the June hike in 2017. Now it remains up for debate on whether that next hike will come in December of 2017 or in January of 2018.

A more simple view on when rate hikes actually will come is from the CME’s FedWatch Tool. This spells it all out in plain percentages, and that suggested on Friday that there was a 99.6% chance that the FOMC would raise fed funds to a 1.00% to 1.25% range for the June meeting.

Again, it is further out the curve that rate hikes are up for debate. As far as when fed funds will be raised to a 1.25% to 1.50%, the odds are as follows:

• 2.8% at the July 26, 2017 meeting
• 23.4% at the September 20, 2017 meeting
• 25.0% at the November 1, 2017 meeting
• 40.1% at the December 13, 2017 meeting

It is 2018 where the argument for a rate hike becomes more murky. The FedWatch Tool shows a 48.7% chance that fed funds will still be in a 1.00% to 1.25% range and a 40.5% chance that they will be in the 1.25% to 1.50% range. To make matters even more unpredictable, there was a 10% chance that the fed funds rate will be in a range of 1.50% to 1.75%.

Even out in May of 2018, the FedWatch Tool shows a 41.9% chance for 1.00% to 1.25% and 41.5% chance for a range of 1.25% to 1.50%.

And on the Fed’s $4.459 trillion balance sheet, the real debate is whether the Fed will start selling its Treasury or mortgage-backed securities debt instruments. In the past, there was what was referred to as “the taper tantrum,” where investors worried that the slowing down of asset purchases under the Fed’s quantitative easing was going to drive up interest rates too fast (and no, that did not happen).

Initially it is expected that the Fed will stop or slow down its reinvestment of funds. That almost has to occur before the Fed begins selling assets outright. The FOMC’s May 3, 2017 statement on rates and further asset purchases said:

The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.

It is the “anticipates doing so until normalization of the level of the federal funds rate is well under way” potion of the statement that should matter the most here. This means it can start to work toward not reinvesting into more assets almost any time, but it implies that outright asset sales by the Federal Reserve are not on the immediate horizon.

On June 1, 2017, Fed governor Jerome Powell spoke to the Economic Club of New York about his thoughts on the normalization of monetary policy. Specifically, this was on his views of the prospects for returning both the fed funds rate and the size of the Fed’s balance sheet to more normal levels. Some of his comments were as follows:

If the economy performs about as expected, I would view it as appropriate to continue to gradually raise rates. I would also see it as appropriate to begin the process of reducing the size of the balance sheet later this year.

Both the federal funds rate and the balance sheet are currently set at levels intended to provide significant support to economic activity. Normalization of the stance of monetary policy will return both tools to a more neutral setting over time.

Normalization of the balance sheet will commence only after the normalization of the level of the federal funds rate is well under way. Most FOMC participants think that this condition will be satisfied later this year if the economy continues broadly on its current path.

The balance sheet will be allowed to shrink passively as our holdings of Treasury and agency securities mature (or prepay) and roll off.

The process will be gradual and predictable. As noted in the May minutes, although no decisions have been made, the Committee has discussed preannouncing a schedule of gradually increasing caps on the dollar value of securities that would be allowed to run off in a given month.

Once the process of balance sheet normalization has begun, it should continue as planned as long as there is no material deterioration in the economic outlook.

Even in the low case in which reserves decline to $100 billion, our balance sheet would be about $2.4 trillion in 2022 and would grow from there in line with currency demand. If the long-run level of reserves is $600 billion in 2022, then the balance sheet would be about $2.9 trillion.

Stay tuned.