The Federal Reserve held interest rates steady and released
a 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 minutes
are revealed in a few weeks.
There is a strong chance that at this meeting the Federal Open Markets
Committee (FOMC) began more formal discussions of its longer-term monetary
policy implementation framework, specifically whether to continue to
implement monetary policy through the “floor” system, which uses the
interest that the Fed pays on bank’s excess reserve balances (IOER)
to control the fed funds rate. This is important because maintaining the
floor system would require the Fed to maintain a bigger balance sheet than
it otherwise would have.
Decision pending: “Floor” or “corridor”
Although the FOMC has discussed its longer-run strategy for monetary policy
implementation in the past, it has yet to make a formal decision regarding
the continued use of IOER when reserve balances normalize. However, the
recent increase of the fed funds rate into the higher end of the target
range has likely accelerated the need for a more formal decision. Indeed,
in his semiannual testimony to Congress in mid-July, Fed Chairman Jerome
Powell said the committee was planning to return to this question “fairly
Amid the Fed’s quantitative easing programs, which greatly increased the
level of excess reserves in the banking system, IOER has been a more
effective tool to manage interest rates. However, when reserves return to
more normal levels, the Fed must decide whether to maintain the current
system, or return to a “corridor” approach, whereby the open market
operations desk would run daily reserve management operations to change the
supply of reserves so that the market interest rate is as close as possible
to the target.
We think the Fed will continue to use IOER because it allows the Fed to
operate monetary policy with a larger balance sheet. Regulations after the
financial crisis in 2008 have resulted in greater demand for what are
perceived as highly liquid “safe assets,” including reserves, which argues
for a permanently larger Fed balance sheet.
Interest rate outlook
After the meeting minutes are released in a few weeks, the focus will
likely shift to the next FOMC meeting on 25‒26 September. We maintain our
view 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. Over
the next two months Fed officials will have additional opportunities to
signal their post-September plan. These include Chairman Powell’s speech at
the annual Jackson Hole Economic Symposium at the end of August and the
FOMC’s updated forecasts and post-meeting press conference in September.
The market is pricing in about three more interest rate hikes between now
and the end of 2019 – well under the median FOMC participant expectation of
five additional rate hikes.
We continue to believe that one or two more interest rate hikes in 2018
would be appropriate to bring monetary policy into the neutral range within
our “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 Grows
as policy rates near neutral, the Fed has the tricky task of setting
monetary policy, which effectively balances the risk of overtightening
policy 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?”
is a PIMCO economist focusing on the U.S. and is a regular contributor