Fed Balance Sheet Normalization: Signed, Sealed, Delevered

Fed Balance Sheet Normalization: Signed, Sealed, Delevered

Going into today’s important Federal Reserve meeting (with a press conference and an update to the economic projections, aka the “dot plot,” along with the usual statement), we at PIMCO along with most market participants expected the Fed to announce formally the start of balance sheet reduction this fall, perhaps in October. And that’s exactly what the Federal Open Market Committee (FOMC) did.

Winding down the Fed’s balance sheet

The plan for balance sheet reduction had already been agreed to and announced at the June 2017 meeting in an “Addendum to the Policy Normalization Principles and Plans.” The Fed confirmed in its implementation note today that to make the process predictable – if not passive – caps will be placed on the maximum dollar amount of U.S. Treasuries and mortgage-backed securities (MBS) that will be allowed to roll off each month. These caps will be set initially at $4 billion for MBS and $6 billion for Treasuries, and will be raised quarterly until they reach $20 billion and $30 billion, respectively, one year from now. These caps will be binding for many months, which means the Fed will still be buying MBS and Treasuries even after it starts the process of reducing its balance sheet next month. (Please see our recent Global Central Bank Focus for more on the normalization plan.)

Still to be decided is the ultimate destination for the balance sheet. Most likely this will be a decision led by the next Fed chair – or Janet Yellen if she is reappointed – as the current FOMC seems satisfied to get the process of balance sheet normalization underway and defer until the future the hard decision of how big a balance sheet it wants.

Policy rate outlook: intriguing clues from the dot plot

Ahead of today’s meeting, many observers were speculating about the new dot plot: Would the dots continue to show an FOMC inclined to hike the policy rate later this year? And perhaps more importantly, would the “longer run” dots shift down, which would indicate the Fed is lowering its estimate of the longer run neutral policy rate squarely into PIMCO’s New Neutral range?

The September dot plot released today indeed shows the median FOMC participant is inclined to hike the fed funds rate by year-end 2017 and also has marked down her or his longer run dot to 2.75% (from 3% in the previous dot plot in June).

Interestingly, the FOMC dot plot now clearly indicates that many on this committee expect that the Fed may have to overshoot the longer run neutral rate. This reflects the fact that the Fed’s statement of economic projections (SEP) shows U.S. unemployment falling to 4.1% over the next two years, well below the unchanged estimate of NAIRU of 4.6% (NAIRU, or the non-accelerating inflation rate of unemployment, is the estimated rate of unemployment that does not spur inflation). To keep projected U.S. inflation at 2% – and according to the SEP, the Fed expects to see 2% inflation by 2019 – the Fed’s models, and several of the dots, indicate this would call for a tighter-than-neutral policy rate. Each dot in the plot tells a story – but the eventual outcome is not yet written.

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.

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Richard Clarida is PIMCO’s global strategic advisor and a frequent contributor to the PIMCO Blog.

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