Jefferies

Economics and Strategy

U.S. Outlook – Federal Reserve Initiates Balance Sheet Normalization, Refocuses on Rates

— Ward McCarthy, Chief Financial Economist

At the September 20 FOMC meeting, the Federal Reserve announced a change in the System Open Market Account (SOMA) reinvestment policy and the beginning of balance sheet normalization in the U.S. effective in October.

The pace of U.S. balance sheet normalization had previously been laid out in the “Addendum to the Policy Normalization Principles and Plans” that the FOMC released in June. The process of rolling-off U.S. balance sheet security holdings is scheduled to begin slowly, with the initial roll-off caps for Treasuries of $6 billion and a $4 billion cap for MBS. The size of the caps will increase by $6 billion at 3-month intervals for Treasuries and increase by $4 billion at 3-month intervals for MBS. The maximum roll-off will be $30 billion for Treasuries and $20 billion for MBS. The FOMC projections indicate that the normalization process would reduce the size of the Federal Reserve SOMA balance sheet security holdings by $1.75 trillion over the next three and one half years.

There are still significant issues about the U.S. balance sheet normalization process that need to be addressed. For example, it is not clear why the interest rate normalization process is data dependent, but the balance sheet normalization process would only be altered in the event of a “material deterioration in the outlook” that the FOMC could not address with adjustments to the federal funds rate.

The FOMC also remains noncommittal about the target size of balance sheet securities holdings and has been ambiguous about the longer-term goal for the composition of such. While the balance sheet normalization process that will be initiated in October will reduce the size of the balance sheet, it will not return the composition of SOMA security holdings to the pre-crisis composition because it will reduce but not eliminate all of the MBS holdings. Pre-crisis, roughly one third of SOMA securities holdings were comprised of Treasury bills, but the balance sheet normalization process does not increase bill holdings.

So, the FOMC still has work to do in order to normalize both the size and the composition of securities holdings.

In addition, Fed policymakers left the Interest Rate on Excess Reserves (IOER) and fed funds rate target range unchanged at the September 20 FOMC meeting but signaled that the FOMC intends to resume raising rates going forward. The combination of the September 20 policy statement and the Summary of Economic Projections (SEP) indicated that the FOMC is ready to refocus attention back to rate normalization once the balance sheet normalization process has been initiated in October. This reinforces the message from reserve bank presidents Bill Dudley, Loretta Mester and Esther George, who have all made recent public comments suggesting the FOMC is ready to resume rate normalization, with the next rate hike possibility being as early as the December FOMC meeting. The SEP also kept three rate hikes on the table in 2018.

Finally, the September 20 policy statement acknowledged that the recent spate of hurricanes will cause “storm-related disruptions” to U.S. economic activity in the near-term and also recognized that increases in prices of “gasoline and some other items in the aftermath of the hurricanes will likely boost inflation temporarily.” Nonetheless, policymakers were inclined to continue along the path of normalizing U.S. monetary policy because “past experience suggests that the storms are unlikely to materially alter the course of the national economy in the medium-term.”

Nonetheless, the confusing picture that is likely to emerge from the high frequency data releases in the months ahead will complicate the policy decision process in the U.S.