The Federal Reserve embarks on a tricky path back to normal

Posted by on September 21, 2017

The Federal Reserve decided to stand pat on interest rates Wednesday, but it’s not standing still on U.S. monetary policy. Beneath the surface of the rate announcement, the central bank is embarking on a largely uncharted journey of policy tightening that will take years to complete: the unwinding of the Fed’s $4.5-trillion (U.S.) balance sheet.

And the nominal excuse for the Fed to hold the line on further rates hikes for the time being – the series of hurricanes that have battered the southern United States and seriously disrupted economic activity – may have bought the Fed some useful time. It has a few months to test how financial markets handle its unprecedented effort to chip away at this massive remnant of the financial crisis, without the pressures of rate hikes adding to the noise.

The more immediate and headline-grabbing news out of Wednesday’s rate announcement, of course, was the Fed’s key rate itself: The Fed held its target for the federal funds rate at 1 per cent to 1.25 per cent, where it has sat since June, following three quarter-percentage-point rate hikes in the prior six months. This was widely expected, especially given the perplexing lack of U.S. inflation in recent months, which remains well below the Fed’s 2-per-cent objective despite a solid economy and tight labour market. The significant economic impact from the brutal Caribbean hurricane season of the past month sealed the deal.

The storms certainly tapped the brakes on U.S. growth for the near term, removing the urgency for further rate increases.

On the other hand, the Fed remained unshaken in its confidence that the economy’s underlying strong trend remains intact, and that the sluggish inflation is temporary. Its quarterly update of its economic outlook, released in conjunction with the announcement, actually showed a slight increase in growth projections for this year and largely held the line on inflation projections.

Crucially for financial markets, the Fed’s projections of the path for the federal funds remained essentially unchanged for this year and next – Fed officials still see one more quarter-point increase before the end of this year (probably December), and three such hikes next year.

Currency traders were clearly enthused by the Fed’s steady-as-she-goes view. The U.S. dollar jumped 0.7 per cent against a basket of other major currencies in response to the news.

Amid all this, the Fed quietly confirmed that it would begin reducing the size of its bloated balance sheet, ever so slowly (just $10-billion a month, initially), starting in October. The plan had been telegraphed to financial markets in June, with October pencilled in as the start of the process by most observers. Still, expected or not, this is the beginning of a very big deal.

The Fed expanded its balance sheet to unheard-of levels during the 2008-2009 financial crisis and its lingering economic aftermath, first to stave off financial and economic collapse, and then to keep the U.S. economy on what was effectively a monetary respirator until it could return to normal strength. The balance-sheet expansion was result of the Fed’s so-called quantitative-easing programs – buying up financial assets to keep money flowing through the economy. By all accounts, it worked; a much worse economic disaster was averted.

But dealing with one enormous eventual consequence of buying all these assets – reversing all that buying, putting all those assets back into the open market – amounts to a great unknown. The Fed has never done this before.

It believes its strategy to do so gradually, according to a fixed schedule and slowly increasing the amounts, and signalled very clearly and well in advance to the financial markets, will allow for a smooth process with minimal market volatility. But with this being unknown territory, it can’t be sure.

This is going to be something going on in the background of the markets for the next four or five years. How will it affect market interest rates, and the U.S. dollar? Lots of experts have theorized on that, both inside and outside the Fed. Ultimately, no one knows. The Fed well remembers the so-called “taper tantrum” of 2013, when the markets gyrated violently when it announced that it merely intended to gradually reduce the size its purchases under its QE program.

And the Fed’s balance sheet isn’t the only one that will be unwinding over the next half-decade; indeed, it’s not even the biggest. The markets will have to absorb a lot more when the European Central Bank ($5.2-trillion) and the Bank of Japan ($4.6-trillion) start whittling down their enormous positions. In theory, maybe this can be done relatively smoothly, without seriously disrupting and distorting the world’s financial markets. In practice? There’s no historical precedent.

In a way, then, the hurricane impacts have afforded the Fed a chance to give its balance-sheet unwinding an initial test drive in a less pressured environment. The U.S. growth outlook for the third and fourth quarters has cooled, putting the rate hikes on the back burner for the markets. That means that the Fed can observe the impacts of its initial balance-sheet reversals more in isolation, without rate uncertainties muddying the waters. At the same time, the typically temporary nature of disaster-related economic slowdowns means the markets needn’t fret that the economy and the rate outlook have drifted off course; they are merely delayed, not derailed.

Officially, of course, the Fed isn’t happy about those hurricanes; it expressed its sympathies for the victims of Harvey, Irma and Maria on Wednesday. But a dispassionate eye can see that this may have actually bought the Fed a valuable chance to see around the first turn on a very long and hazy road to finally bringing its balance sheet back to normal.

Courtesy: The Globe And Mail

Posted in: Business Insight

Comments

Be the first to comment.

Leave a Reply

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <s> <strike> <strong>

Simple Business by Nimbus Themes
Powered by WordPress