Jefferies

Economics and Strategy

U.S. Outlook – Federal Reserve Accelerates Policy Normalization

— Ward McCarthy, Chief Financial Economist

The combination of the June 14 policy statement, the Summary of Economic Projections (SEP) and Janet Yellen press conference reinforced the Fed’s commitment to an accelerated normalization process for both the fed funds rate and a reduced size of the balance sheet.

The precise time line has yet to be clarified, but Fed “smoke signals” point to a preferred FOMC 2017 time line for one more rate hike in September, as well as the first step in the System Open Market Account (SOMA) balance sheet normalization process in December when the FOMC also “pauses” the rate normalization process.

Regardless of the timing, the FOMC will utilize the September and December meetings to implement one more rate hike and initiate the balance sheet normalization process.

As expected on June 14, the FOMC raised its Interest Rate on Excess Reserves (IOER) by 25 basis points to 1.25% and raised the fed funds rate target range by 25 basis points to a 1 - 1.25% range. The Board also voted to raise the discount rate by 25 basis points from 1.5% to 1.75%.

There was no change to SOMA reinvestment policy at this time, but the FOMC provided an “Addendum to the Policy Normalization Principles and Plans” that lays out a fairly aggressive trajectory for the normalization of the balance sheet. The plan begins slowly, with a $6 billion cap for Treasuries and a $4 billion cap for Mortgage Backed Securities (MBS), but these will increase at 3-month intervals by $6 billion for Treasuries and $4 billion for MBS. The cap for Treasuries will peak at $30 billion and the MBS cap will peak at $20 billion.

There are still lingering questions about the balance sheet normalization process. For example, there is no indication of the specific timing of the implementation of the change in reinvestment policy, although the FOMC indicated that it is set to begin before the end of 2017. Additionally, the FOMC has not provided guidance on a specific target size for a reduced balance sheet beyond Janet Yellen’s comments that the reduced balance sheet will be “appreciably” below the current size. Without a specific target size for the “terminal” balance sheet, it is impossible to know the length of time that the FOMC envisions for the balance sheet normalization process.

Janet Yellen’s comments at her press conference were dismissive of the deceleration in inflation since the February data was released. For example, she described recent lower readings on inflation as being “driven significantly by what appear to be on/off reductions in certain categories of prices such as wireless telephone services and prescription drugs” that will “restrain the twelve-month inflation figures until the extraordinarily low March reading drops out of the calculation.”

These comments lower the bar for the inflation mandate and appear to suggest that the Fed is inclined to use the weak March data as a reason to below-target year-over-year inflation readings for as much as a year.

In short, after years of delaying the normalization process, Janet Yellen and the majority of FOMC members appear to have flipped to being less dovish and appear to be on a mission to get normalization on a steady path.

Finally, the relatively aggressive wind-down of the Fed SOMA Treasury holdings will increase Treasury financing needs dollar-for-dollar with the decline in these holdings on the Fed portfolio. The market implications of the upcoming changes in Fed reinvestment policy will depend primarily on the changes to Treasury financing that result from the Fed’s balance sheet normalization, most notably the distribution of this increased issuance across the curve.