The news coming out of the July Federal Open Market Committee (FOMC) meeting was a reference in the statement that the Federal Reserve expected to begin to implement its balance sheet normalization program “relatively soon,” which we (along with many market participants) took to mean at the upcoming September meeting. In the minutes of July’s meeting, released Wednesday, we learn that the Fed indeed wanted to “clarify the time at which” it expected to begin this drawdown process and inserted the “relatively soon” language for that purpose.
So while there is no additional hint in the minutes that the FOMC has agreed to make a balance sheet announcement in September, that continues to be the most likely outcome – barring actual or expected market turmoil arising from concerns over U.S. policymakers extending the debt limit or funding the government.
Balance sheet news unlikely to rattle markets
In any event, PIMCO does not expect the formal balance sheet announcement (whenever it happens) to be a significant market event. This is because the Fed’s plans – which we’ve discussed before in this blog – have been well-telegraphed and specifically designed to minimize market disruption: The Fed will set caps on the maximum roll-off of mortgage-backed securities (MBS) and U.S. Treasuries taking place each month. As we’ve noted, even after the balance sheet is allowed to begin to shrink, the Fed will continue for up to a year to be a big buyer in the MBS and Treasury markets as it seeks to enforce these caps.
The July minutes were silent on the ultimate destination for the size of the Fed balance sheet. We expect this important decision will be left to the next Fed chair, or to Janet Yellen in her second term if she is reappointed.
Inflation and the next rate hike
July’s minutes were perhaps most revealing on the growing concerns within the FOMC over the Phillips curve framework, which undergirds the baseline expectation of “most participants” that U.S. inflation will pick up over the next couple of years and stabilize “around the Committee’s 2% objective over the medium term.” However, after four (at the time of the meeting, and now five) consecutive months of downside misses versus the consensus forecast for the consumer price index (CPI), inflation doubts seem to be creeping into the Eccles Building. Indeed, “many participants” now see “some likelihood” that inflation may remain below 2% for longer than they currently expect. But others, we are told, “expressed concerns about the possibility of substantially overshooting full employment.”
For now, these opposing views among Fed policymakers appear to be canceling each other out. Whether or not the Fed hikes one more time this year, as the “dot plot” released in June indicated they might, will indeed be data – especially inflation data – dependent.
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.