FOMC’s balance sheet drawdown program is so far imperceptible but will start to bite by late 2018
Regarding today’s FOMC meeting decision, the market is discounting a 100% chance of a +25 bp rate hike to a new funds rate target of +1.25%-1.50%
Fed Chair Yellen today will hold a press conference after the FOMC meeting
CPI expected to remain near Fed’s inflation target
FOMC’s balance sheet drawdown program is so far imperceptible but will start to bite by late 2018 — The Fed in October began its balance sheet drawdown program. The nearby chart of the Fed’s balance sheet level shows that the decline is so far imperceptible.
Since the Fed’s balance sheet drawdown program began on October 1, the Fed’s balance sheet asset level has dropped by -$19 billion through the first week of December. That is roughly in line with the Fed’s stated drawdown program, which started out at $10 billion per month during Q4.
The Fed’s drawdown amount will then increase by $10 billion per month each quarter until it reaches its maximum size of $50 billion per month. That means that the drawdown will be $20 billion per month in Q1-2018, $30 billion per month in Q2-2018, $40 billion per month in Q3-2018, and the maximum of $50 billion per month in Q4-2018.
The Fed’s balance sheet drawdown program in 2019 and beyond will then continue at a maximum amount per month of $50 billion. The Fed has not yet stated an ending date for its drawdown program or the final target for its balance sheet level. The final target for its balance sheet level depends on the Fed’s future decision on whether it plans to run monetary policy with a floor or a corridor system.
The Fed’s balance sheet reduction program has so far lived up to the Fed’s prediction that the program would be like “watching paint dry.” However, the program will start to bite in 2018 as its size progressively increases. The Fed’s drawdown program represents a tightening of monetary policy since the Fed is withdrawing reserves from the banking system. The Fed’s drawdown program also puts some upward pressure on T-note yields as the Fed progressively steps away from being a buyer of T-notes to replace expiring securities in its portfolio. The effects of the Fed’s drawdown program will therefore have an increasing effect on Treasury yields as 2018 wears on, particularly since the drawdown will be reinforced by the Fed’s current intent to raise the federal funds rate three times in 2018.
Regarding today’s FOMC meeting decision, the market is discounting a 100% chance of a +25 bp rate hike to a new funds rate target of +1.25%-1.50%. Today’s rate hike would make good on the Fed-dot forecast for three rate hikes in 2017.
Looking into 2018, the Fed-dot forecasts anticipate another three rate hikes in 2018. The market is discounting a low 10% chance for a rate hike at the next FOMC meeting on Jan 30-31. However, the market is discounting a higher 72% chance for a rate hike at the following meeting on March 20-21 and is discounting a 100% of that rate hike by the May 1-2 meeting.
The federal funds market continues to doubt the Fed’s resolve and is discounting only about two rate hikes for 2018 versus the Fed’s current forecast for three rate hikes. However, if the current strength in the labor market and economy continue, we believe the Fed will make good on its forecast for three rate hikes in 2018. Even with three rate hikes, the funds rate by the end of 2018 would be at only 2.125%, which would be just modestly positive on an inflation-adjusted basis. When the federal funds rate turns positive on an inflation-adjusted basis, it will start to bite harder into the real economy.
Fed Chair Yellen today will hold a press conference after the FOMC meeting. Today’s press conference will be Ms. Yellen’s last because the next FOMC meeting on Jan 30-31 does not have a scheduled press conference. Ms. Yellen is then due to step down as Fed Chair in February when her Chair term expires and Jerome Powell takes over as the new Fed Chair. Mr. Powell’s appointment was already approved by the Senate Banking Committee by the nearly unanimous vote of 22-1, but has not yet been voted upon by the full Senate. However, Mr. Powell is expected to win easy approval by the full Senate as well.
CPI expected to remain near Fed’s inflation target — The market consensus is for today’s Nov CPI to strengthen to +2.2% y/y from Oct’s +2.0%. However, the Nov core CPI is expected to be unchanged from Oct’s +1.8% y/y. The current CPI statistics are close to the Fed’s inflation target of +2.0%. However, they are weaker than the highs seen about a year ago when the headline CPI posted a 5-3/4 year high of +2.7% y/y in February 2017 and the core CPI posted a 9-year high of +2.3% in January 2017.
While the CPI statistics are close to the Fed’s +2.0% inflation target, the PCE deflator statistics are much lower. In October, the PCE deflator was at +1.6% y/y and the core PCE deflator was at +1.4% y/y. The PCE deflator is the Fed’s preferred inflation measure.
The Fed has some unease about the soft inflation statistics since the CPI eased during 2017 and since the PCE deflator is below target. Nevertheless, the Fed in 2017 proceeded with its rate-hike regime despite the soft inflation statistics.
We look for the Fed to continue its rate-hike regime in 2018 even if the inflation statistics remain weak because we believe the Fed wants to at least get the funds rate up to a positive inflation-adjusted level in order to avoid over-inflating asset prices and excessive risk taking.