The news coming out of the July Federal Open Market Committee (FOMC)meeting was a reference in thestatementthat the Federal Reserve expected to begin to implement its balance sheetnormalization program “relatively soon,” which we (along with many marketparticipants)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 thetime 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 hasagreed to make a balance sheet announcement in September, that continues tobe the most likely outcome – barring actual or expected market turmoilarising from concerns over U.S. policymakers extending the debt limit orfunding 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 theFed’s plans – which we’ve discussed before in this blog– have been well-telegraphed and specifically designed to minimize marketdisruption: The Fed will set caps on the maximum roll-off ofmortgage-backed securities (MBS) and U.S. Treasuries taking place eachmonth. As we’ve noted, even after the balance sheet is allowed to begin toshrink, the Fed will continue for up to a year to bea big buyer in the MBS and Treasury marketsas it seeks to enforce these caps.
The July minutes were silent on the ultimate destination for the size ofthe Fed balance sheet. We expect this important decision will be left tothe next Fed chair, or to Janet Yellen in her second term if she isreappointed.
Inflation and the next rate hike
July’s minutes were perhaps most revealing on the growing concerns withinthe FOMC over thePhillips curveframework, which undergirds the baseline expectation of “most participants”that U.S. inflation will pick up over the next couple of years andstabilize “around the Committee’s 2% objective over the medium term.”However, after four (at the time of the meeting, and now five) consecutivemonths ofdownside misses versus the consensus forecast for the consumer priceindex (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 aretold, “expressed concerns about the possibility of substantiallyovershooting full employment.”
For now, these opposing views among Fed policymakers appear to be cancelingeach other out. Whether or not the Fed hikes one more time this year, asthe “dot plot” released in June indicated they might, will indeed be data – especiallyinflation 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.