Despite a flow of weak economic data in recent months, markets had expected the Federal Reserve's decision today to hike the federal funds rate and boost the amount it pays on its reverse repo facility. Markets understood that the Fed's decision to hike the fed funds rate by 25 basis points (bps) to 1.25% and the reverse repo rate by 25 bps to 1.0% would not be based solely on the flow of economic data since the March and May Fed meetings. Outside of the labor market, the data flow for the U.S. – including another soft U.S. core Consumer Price Index (CPI) inflation report this morning – had been surprising on the downside.
So why hike? The Fed's statement chose to downplay the recent data as temporary. Instead, it put great weight on labor market data that showed the unemployment rate had fallen 0.4 percentage point since the March meeting to 4.3% in May, a level that the Federal Open Market Committee (FOMC) believes represents full employment.
Balance sheet reduction
A second reason to hike was that the Fed wanted to announce today – in an “Addendum to the Policy Normalization Principles and Plans” – details for its process of normalizing its $4.5 trillion balance sheet. The committee had indicated this could only happen once the process of raising rates was "well under way." With today’s action, the Fed has hiked rates four times since December 2015, for a total of 100 bps, the practical minimum for the central bank to pass its self-imposed test. However, even with a policy rate corridor of 1.0% to 1.25%, the real policy rate remains below inflation. To the Fed, this means they are "removing accommodation," not yet "tightening" policy.
As telegraphed in the minutes of the March and May Fed meetings, the committee would like to start reducing its balance sheet later this year and communicate this clearly well in advance with pre-announced caps on the dollar value of Treasury and mortgage-backed securities (MBS) it will allow to roll off each month. Initially, the caps will be set at $6 billion per month for Treasuries and $4 billion per month of MBS. The FOMC anticipates raising these in three-month intervals, in equal amounts, so that in 12 months the caps – which will remain in place – would be $30 billion for Treasuries and $20 billion for MBS. In months when Treasury maturities and MBS pre-payments exceed these levels, the Fed would enforce the caps by continuing to purchase these securities to keep the pace of balance sheet reduction predictable.
Future rate hikes
Markets also had expected the data in the Summary of Economic Projections. The "dot plot" continues to indicate one more hike this year (for a total of three) and an additional three hikes next year. By the end of 2018, with inflation projected to be very close to the 2% target, and with the economy predicted to be at or above full employment, the Fed foresees a fed funds rate of about 2.0%, consistent with PIMCO’s New Neutral thesis.
However, this implied "dot plot" liftoff path is not priced in to markets, which expect a fed funds rate of only 1.5% by year-end 2018. The statement noted that the FOMC will continue to monitor inflation developments closely. As will the markets and PIMCO.
For more of our views on inflation, monetary policy and economic growth over the long term, please read PIMCO’s 2017 Secular Outlook, “Pivot Points.”
Visit PIMCO’s Rise Above Rates page for our most up-to-date outlook for interest rates and insight into how we expect financial markets to be affected.
Richard Clarida is PIMCO’s global strategic advisor and a frequent contributor to the PIMCO Blog.