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Fed to Begin Balance Sheet Reduction In October

Posted by Joseph Trevisani on Sep 20, 2017 6:16:18 PM

Federal Reserve officials said on Wednesday that the central bank would begin its long awaited balance sheet reduction in October along the lines laid out in June.  They also project one more rate hike this year, three next year, inflation below their 2 percent target until 2019 and only transitory economic fallout from the string of powerful storms in the South and Caribbean.

"Hurricanes Harvey, Irma, and Maria have devastated many communities, inflicting severe hardship. Storm-related disruptions and rebuilding will affect economic activity in the near term, but past experience suggests that the storms are unlikely to materially alter the course of the national economy over the medium term," said the FOMC statement.

The Fed Funds target rate was left unchanged at 1 percent to 1.25 percent as expected.

Markets were divided in reaction to the results of the FOMC meeting.  The dollar rose sharply against all its major counterparties on the prospect of higher interest rates in the U.S. The euro lost more than a figure and a half versus the greenback closing at 1.1894 having been as high as 1.2033 before the 2 pm  decision. Sterling closed at 1.3490 down from its high of 1.3657 top and dollar/yen finished at 112.14 up over a figure from its low of 111.11.

Treasuries fell boosting the return on the 10-year by 2 basis points to 2.27 percent. The return is down from 2.45 percent at the start of the year. The 2-year jumped 4 points to 1.44 percent. This was the highest yield for this benchmark bond since 2008.

Equities initially sold off as rising interest rates are traditionally a drag on economic activity but by the close the Dow and S&P 500 had recovered to minor gains of 0.19 percent and 0.06 percent respectively. The Nasdaq Composite was essentially unchanged down 0.08 percent.  It was the Dow's tenth record close in a row.

The Fed's projections for the U.S. economy through 2019 saw only small changes from the June numbers. The estimate for GDP this year climbed to 2.4 percent from 2.2 percent and in 2019 it rose to 2.0 percent from 1.9 percent; 2018 was the same at 2.1 percent.

Unemployment remained at 4.2 percent this year, with 2018 falling from 4.2 percent to 4.1 parent. Overall the estimate for the personal consumption expenditure price index (PCE) the Fed's preferred inflation measure, remained at 1.6 percent this year but the core PCE index fell from 1.7 percent in June to 1.5 percent. It is now projected to reach the Fed's 2 percent target in 2019.  The annual core PCE rate was 1.4 percent in July.

Federal Reserve economists have been anticipating 2 percent inflation a year or two out for most of the past five years but the rate has not been at 2 percent since April 2012. 

The economy expanded at a 2.1 percent annual pace in the first half of the year with the second quarter's 3 percent pace the strongest growth since the first quarter of 2015. 

Since the financial crisis of 2008 the U.S. has averaged about 2.2 percent annual growth, the longest period without at least one year of 3 percent expansion in over 50 years.  The latest estimate from the Atlanta Fed's GDPNow model posits a 2.2 percent rate in the third quarter. 

In June the FOMC set out its program for selling off its portfolio of Treasuries and commercial securities. The central bank has been keeping its balance sheet at about $4.5 trillion since it stopped purchasing new securities in October 2014 by reinvesting the principle from maturing securities. That reinvestment will be continue only to the amount that it’s exceeds a gradually rising limit or cap. 

For Treasuries "the cap will be $6 billion per month initially and will increase in steps of $6 billion at three-month intervals over 12 months until it reaches $30 billion per month," noted the FOMC in June. 

"For payments of principal that the Federal Reserve receives from its holdings of agency debt and mortgage-backed securities, the Committee anticipates that the cap will be $4 billion per month initially and will increase in steps of $4 billion at three-month intervals over 12 months until it reaches $20 billion per month."

Wednesday's announcement of the curtailment of the Fed balance sheet is the third big policy step for Janet Yellen, now in the last year of her term as Fed chair with uncertain reappointment. This is the final step in ending the emergency policies instituted by her predecessor Ben Bernanke to cope with the economic and financial fallout from the crisis of 2008.   

Ms Yellen and the FOMC ended  large-scale asset purchases almost three years ago, began to increase rates a year later in December 2015 and have now have started  to draw down the unprecedented balance- sheet buildup.

This has been achieved without disruption to financial markets or the economy, an achievement that is considerably more important than the central bank’s inability to bring inflation to its target. .

Joseph Trevisani

Chief Market Strategist

WorldWideMarkets Online Trading

Charts: Federal Reserve, St Louis Federal Reserve, Thomson/Reuters

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