The Federal Reserve held interest rates steady and releaseda statement on 1 August that made only minor changes to reflect the more upbeat U.S.economy since the Fed’s June meeting. Despite the lack of surprises,however, we don’t think investors should write off the meeting just yet:The more interesting aspect may well come later ‒ when the meeting minutesare revealed in a few weeks.
There is a strong chance that at this meeting the Federal Open MarketsCommittee (FOMC) began more formal discussions of its longer-term monetarypolicy implementation framework, specifically whether to continue toimplement monetary policy through the “floor” system, which uses theinterest that the Fed pays on bank’s excess reserve balances (IOER)to control the fed funds rate. This is important because maintaining thefloor system would require the Fed to maintain a bigger balance sheet thanit otherwise would have.
Decision pending: “Floor” or “corridor”
Although the FOMC has discussed its longer-run strategy for monetary policyimplementation in the past, it has yet to make a formal decision regardingthe continued use of IOER when reserve balances normalize. However, therecent increase of the fed funds rate into the higher end of the targetrange has likely accelerated the need for a more formal decision. Indeed,in his semiannual testimony to Congress in mid-July, Fed Chairman JeromePowell said the committee was planning to return to this question “fairlysoon.”
Amid the Fed’s quantitative easing programs, which greatly increased thelevel of excess reserves in the banking system, IOER has been a moreeffective tool to manage interest rates. However, when reserves return tomore normal levels, the Fed must decide whether to maintain the currentsystem, or return to a “corridor” approach, whereby the open marketoperations desk would run daily reserve management operations to change thesupply of reserves so that the market interest rate is as close as possibleto the target.
We think the Fed will continue to use IOER because it allows the Fed tooperate monetary policy with a larger balance sheet. Regulations after thefinancial crisis in 2008 have resulted in greater demand for what areperceived as highly liquid “safe assets,” including reserves, which arguesfor a permanently larger Fed balance sheet.
Interest rate outlook
After the meeting minutes are released in a few weeks, the focus willlikely shift to the next FOMC meeting on 25‒26 September. We maintain ourview that the Fed will announce another 25-basis-point interest rate hike,bringing the target fed funds rate range to 2.00%‒2.25%.
The interest rate outlook after September, however, is more uncertain. Overthe next two months Fed officials will have additional opportunities tosignal their post-September plan. These include Chairman Powell’s speech atthe annual Jackson Hole Economic Symposium at the end of August and theFOMC’s updated forecasts and post-meeting press conference in September.The market is pricing in about three more interest rate hikes between nowand the end of 2019 – well under the median FOMC participant expectation offive additional rate hikes.
We continue to believe that one or two more interest rate hikes in 2018would be appropriate to bring monetary policy into the neutral range withinour “New Neutral” framework, but the policy outlook becomes even more uncertain next year.As discussed in“The Fed Raises Rates as Expected but the Path of Future Hikes GrowsMore Uncertain,”as policy rates near neutral, the Fed has the tricky task of settingmonetary policy, which effectively balances the risk of overtighteningpolicy with the risk of overheating the economy.
For more on interest rates and Fed policy, please see “Will the Fed Yield to the Yield Curve?”
Tiffany Wildingis a PIMCO economist focusing on the U.S. and is a regular contributorto thePIMCO Blog.