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September 25, 2017

Fed’s Changing, and It's Not Just the Balance Sheet

By Charles Rotblut, CFA, AAII

Last week, the Federal Open Market Committee (FOMC) announced its plan to unwind its balance sheet. Starting next month, the Federal Reserve will stop reinvesting $6 billion of proceeds from maturing Treasury securities and $4 billion proceeds from maturing agency debt and agency mortgage-backed securities. The dollar amounts will be gradually rising each month, subject to adjustments as warranted. The FOMC also updated its forecasts for economic growth, keeping the annual long-term projection for GDP expansion at 1.8%. Interest rates were left unchanged and expectations for how rates will be raised next year trended downward.

All of this is occurring as Fed Chair Janet Yellen’s term will expire in February. It’s not clear who will actually hold the seat when the next term starts. In addition, President Trump will have four Federal Reserve Board vacancies to fill once vice chair Stanley Fischer steps down in October. Former senior Treasury official Randal Quarles’ nomination for the board is currently pending before the Senate.

The sheer number of personnel changes could alter future monetary policy from what it would have been. Yellen’s approach has been dovish. The FOMC under her tenure has been very cautious about raising rates and pulling back monetary stimulus even with a tightening cycle now occurring. A big reason has been lower-than-expected inflation. The chart at the right is an update to one I published a year ago. As you can clearly see, long-term growth expectations—though unchanged from 12 months ago—remain below levels projected in 2012 and 2013.

Whether the president’s appointees to the Federal Reserve will be comparatively more hawkish or dovish remains to be seen. Throughout his real estate career, Trump has relied heavily on borrowing. This would suggest a preference to keeping interest rates low. As long as inflation remains at tame levels, the economic data would make it hard to justify a shift to a significantly more hawkish monetary stance.

This is not to say that there won’t be more interest rate hikes before the current tightening cycle ends. There have been precedents for Federal Reserve chairs to butt heads with the presidents they’ve served under. If a future Fed chair believes there is evidence for an acceleration in the rate of inflation, we could see a more frequent approach to raising rates than we have seen since the first post-financial crisis interest rate hike was announced in December 2015. (There have only be two additional hikes since then.) Whether such a shift would actually occur is highly uncertain.

The other wildcard is the Federal Reserve’s balance sheet. By not reinvesting the proceeds of maturing bonds, the central bank is effectively reducing demand for those bonds. The effect of this on the credit market will be the subject of economic studies and textbooks for decades to come. Fed officials are going to have to be sensitive to any ripples in the credit markets and adjust accordingly. To predict how things will turn out is to make a big guess. It’s an uncertainty, but it’s a well-telegraphed uncertainty and so far the bond markets have not shown signs of fear about it.

The Week Ahead

We’ll see more companies announcing results during what is the run-up to the third-quarter earnings season. Included in the group are S&P members Carnival Corp. (CCL) and Red Hat Inc. (RHT) on Monday; Darden Restaurants Inc. (DRI), IHS Markit Ltd. (INFO), Micron Technology Inc. (MU), Cintas Corp. (CTAS) and Dow Jones industrial average component Nike Inc. (NKE) on Tuesday; and Accenture PLC (ACN), ConAgra Brands Inc. (CAG) and McCormick & Company Inc. (MKC) on Thursday.

The week’s first economic reports will be July S&P Case-Shiller home price index, August new home sales and the Conference Board’s September consumer confidence survey. All three will be released on Tuesday. Wednesday will feature August durable goods orders and August pending home sales. The final revision to second-quarter GDP and August international trade will be released on Thursday. Ending the week, August personal income and spending, the September Chicago purchasing managers’ index and the University of Michigan’s final September consumer sentiment survey will be released on Friday.

Ten Federal Reserve officials will make public appearances. New York president William Dudley, Chicago president Charles Evans and Minneapolis president Neel Kashkari will speak on Monday. Cleveland president Loretta Mester, Atlanta president Raphael Bostic and Fed Chair Janet Yellen will speak on Tuesday. Minneapolis president Neel Kashkari, St. Louis president James Bullard and Boston president Eric Rosengren will speak on Wednesday. Kansas City president Esther George will speak on Thursday. Philadelphia president Patrick Harker will speak on Friday.

The Treasury Department will auction $26 billion of two-year notes on Tuesday, $13 billion of two-year floating rate notes (FRN) and $34 billion of five-year notes on Wednesday and $28 billion of seven-year notes on Thursday.

About The Author - Charles Rotblut, CFA is the VP and Editor for American Association of Individual Investors (AAII). Charles is also the author of Better Good than Lucky. (EconMatters author archive here

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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