Originally published by AMP Capital
The Fed provided no surprises overnight: raising the Fed Funds rate for the fourth time this tightening cycle by another 0.25% to a range of 1-1.25% and signalling that it will start to let its balance sheet decline this year.
In doing so the Fed sounded a little bit more upbeat about the economic outlook. While it made no changes to its growth forecasts it lowered its unemployment and inflation forecasts for this year (a re-run of goldilocks?), but Fed Chair Yellen indicated a preparedness to look through the recent dip in inflation given such data can be “noisy” (just as it looked through a speed up in core CPI inflation through last year).
As a result, the Fed’s so called median dot plot of (Fed committee members’) interest rate expectations was basically unchanged (with one more hike this year and three each in 2018 and 2019) although there was a slight reduction in the number of more hawkish Fed members interest rate expectations. However, the Fed continues to stress that increases in the Fed Funds rate will be “gradual” and conditional on economic data.
Market expectations for US interest rates remain well below the Fed’s dot plot which is understandable to some degree given the ongoing lack of significant inflationary pressures, whereas the Fed is assuming that the tight labour market will flow through to faster wages and inflation at some point.
The Fed also laid out its plans for how it will normalise its balance sheet, that is start to reverse the just over $US4 trillion balance sheet portfolio of bonds it built up as a result of quantitative easing. Basically this will be undertaken by slowing the reinvestment of maturing bonds. This will start at $US6bn a month for Treasury bonds and $US4 bn a month for mortgage backed securities increasing over 12 months until it reaches $US30bn a month for Treasury bonds and $US20bn a month for mortgage backed securities. At this rate the Fed’s balance sheet will have fallen below $US3 trillion by early next decade. Note that this will be undertaken not by selling bonds but by not rolling them over as they mature. Over time this could result in upwards pressure on bond yields but its likely to be gradual and there was no sign of it last night as inflation expectations will have a far greater impact on bond yields. Again the Fed has indicated that the balance sheet reduction will be conditional on the economy continuing to improve, so as with interest rate hikes the Fed will not be on auto-pilot.
Our view is that the Fed will hike rates once more this year in September and commence balance sheet reduction in the December quarter. However, ongoing benign inflation is likely to see a slower path of rate hikes in 2018 and 2019 than the dot plot expectations are currently implying.
The bottom line for investors is that in the absence of significant upside inflation pressures the Fed will remain benign and unlikely to pose a threat to US or global growth and hence share markets. The ongoing narrowing in the interest rate differential between Australia and the US (as the Fed hikes and the RBA holds or cuts) will at some point weigh on the Australian dollar, although at this stage we are still waiting for that.