June 2017

Economics and Strategy (June 14th, 2017)

Fed: One more hike and start of balance sheet normalization in 2017

As widely expected, the Federal Reserve raised the fed funds rate by 25 basis points to 1.25%. The Fed supported its decision to hike by referring to improved economic data such as a pick-up in household spending and continued expansion of business investment. While bemoaning below-target inflation, the Fed continues to expect inflation to stabilize around the 2% objective over the medium term. The FOMC expects that economic conditions will evolve in a manner that “will warrant gradual increases in the federal funds rate”. The Fed is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. But it expects to begin implementing a balance sheet normalization program this year “provided that the economy evolves broadly as anticipated”. When it starts to normalize the balance sheet, it will reinvest only to the extent that the principal payment exceeds gradually rising caps. For Treasuries, the cap is expected to be $6 bn/month, to be increased by $6 bn every three months until hitting $30 bn/month. For agency debt and MBS, the cap will be $4bn/month initially and will increase in steps of $4 bn every three months until hitting $20 bn/month. Neel Kashkari, a known dove, was the only dissenter. He wanted the fed funds rate to remain unchanged.

Press Conference:

Chair Yellen said that it is important the FOMC achieves its inflation target. However, core inflation has been weak, and it is expected to remain below target for some time due to base effects. However, she said the FOMC does not want to react to few data points that can be noisy. She pointed out that the FOMC is confident that the conditions are in place to achieve its 2% inflation target over time. The pace of job creation remains above what is needed to absorb new participants in the labor market. While the Philips curve is flat, it only means it will take more time and a lower unemployment rate to get the desired acceleration in wage inflation. Chair Yellen indicated the FOMC intends to proceed gradually in removing monetary accommodation, in order to keep the expansion on a sustainable path. The shrinkage of the balance sheet is expected to be gradual enough as to “play quietly in the background”. In other words, interest rates will remain the primary tool for conducting monetary policy. The process of reducing the size of the balance sheet could start relatively soon according to Chair Yellen.

Bottom Line:

The Fed expects to deliver one more rate hike this year (a forecast that we share) and to start reducing the size of its balance sheet. However, the FOMC’s plans rest on the economy performing well and, on its confidence, that inflation will rise towards its 2% target over the medium term. The continuing downward revisions of forecasts for the jobless rate just highlights the Fed’s struggles in estimating the non-accelerating inflation rate of unemployment (NAIRU), which explains why wage inflation and hence overall inflation have been much weaker than it expected. Should inflation remain stubbornly weak or unexpected shocks arise, the FOMC is likely to delay further tightening of monetary policy.

Krishen Rangasamy 

Senior Economist

Paul-André Pinsonnault

Senior Economist, Fixed Income