With ambitions to end its reinvestment policy before year-end, the Federal Reserve is now more clearly on a twin track policy normalization strategy of shrinking the balance sheet as well as gradually tightening rates.
*** On rates, the Federal Open Market Committee remains on course for a highly likely rate increase at its mid-June meeting. Beyond June, however, we think a September rate hike will depend largely on whether inflation by then is clearly rising towards the 2% target. As we wrote yesterday, the Fed will be concerned about embedding low inflation expectations with a rate hike if the current softness extends through the summer (see SGH 5/22/17, “Fed: A September Pause”). But if the Fed passes on September, it will likely be a pause rather than a reversal of the rates policy normalization, and would make a December rate hike more certain. ***
*** On balance sheet policy, we expect tomorrow’s release of the May Minutes to show the FOMC making considerable progress, though still short of consensus, on the revised portfolio normalization plans. Multiple technical issues remain, though the Committee is leaning towards a larger rather than minimalist balance sheet, retaining the current floor system with a large cushion of excess reserves versus a return to the pre-crisis reserve-scarcity operating system, and for a tapered roll-off of some maturing assets. We still expect the finalized policy to be unveiled by September, and for the end to reinvestments sometime in the fourth quarter this year. ***
*** In particular, we expect a momentum to build towards a proposed “smaller and sooner” test start to portfolio normalization. A well telegraphed, smaller scale of assets initially rolling off — we assume something like $10 to $15 billion in Treasuries and MBS — would ease the Fed’s anxieties over a repeat of the 2013 “taper tantrum” and potentially allow an earlier start with a “well underway” normalization of rates still below 1.5%. We understand, however, a hard Committee minority remain cautious about the proposal, as well as a larger rather than minimalist end-size, out of concerns it could open the door to a more activist balance sheet management down the road. ***
A September Unveiling Likely
The thrust and tone of the public remarks by a wide range of the Committee members about the balance sheet since the May meeting suggests an impressive progress on the portfolio normalization plans, but we think it will probably take several more meetings to nail down the finalized plans. Along the way, there will be plenty of speeches, perhaps a staff paper or two, and testimonies on Capitol Hill, as it will be critical for Chair Janet Yellen to fully brief Congress on its plans before its final, formal unveiling.
To us, that sort of timeline and intention to thoroughly telegraph the evolving plans as they go puts September into the sweet spot as the most likely meeting to release the plans. All else being equal, by the time the formal plans are unveiled and laid out in a statement and the post -meeting remarks to the press, the balance sheet plans should be a surprise to no one, and its impact on the market limited or already priced in.
That, in turn, may reduce the time needed for the market and the public, and Congress, to digest the implications of the plan, meaning the first roll-off of some maturing assets could begin relatively quickly after that, perhaps as soon as October or November. In any case there would be no particular need to wait until December when, we believe, the Fed will want to retain the option of raising rates again, with or without a rate pause in September, once it has a clearer sense of the scale of the Trump Administration’s fiscal and tax policies.
The plans for the normalization of the portfolio could come earlier than September, but we think that is more unlikely than not, if for any other reason there are still considerable technical and broader issues that still need to be ironed out, which we suspect will take several more FOMC meetings.
For instance, the Committee is still working on whether to reinvest assets not being rolled off into the Treasury’s maturity schedule as they are at present, or to shorten up the portfolio’s duration by rolling into shorter maturities; nor is there an agreement on the end-size of the newly “normalized” balance sheet. Indeed, it may prove more pragmatic to start reducing the balance sheet and extinguishing enough excess reserves from the banking system before a decision on the end-size, to gauge how well the Desk can manage the policy rate in a money market vastly changed since before the crisis.
“Smaller and Sooner”
Along those lines, among the likely points of debate that we think will be evident in the Minutes and which we think quite interesting is a proposal for a smaller and sooner start to the portfolio normalization.
Its most essential features are twofold: first, ending the current reinvestment policies with an initial, tapered roll off of only a small amount of maturing treasuries and MBS each month would minimize any potential market dislocations and allow for a smoother execution by the Open Market Desk in New York, and; second, as the FOMC assesses the impact of the partial roll-off, and if the economy continues to improve, the Committee would have the option to later scale up the pace of the monthly roll-off to whatever amounts it deems appropriate to its overall ambitions to shrink the balance sheet within the context of meeting its twin mandates.
Another attractive feature of the scheme is that it could go a long way to allaying the Fed’s concerns for a “well underway” rates normalization before taking on the uncertain effects of the balance sheet policy. Fed officials have at various times defined the “well underway” guidance as a policy rate at or preferably north of 1.5% or even closer to 2% before undertaking the reduction of the balance sheet.
The thought is to build up a healthy cushion of rates as close to the assumed effective neutral rate as possible in case economic activity falters and the Fed finds itself cutting rates so much it is right back at the effective zero bound. There is likewise some concern that just as QE worked through the portfolio rebalancing channel in reducing the term premium and tightening spreads, reducing the balance sheet may work in the opposite direction, in effect, lowering the current neutral rate and severely limiting the Fed’s ability to normalize the policy rate.
A small scale start to ending the reinvestment policy, however, is that much more unlikely to repress the neutral rate, or inhibit the Fed’s freedom of maneuver to continue raising rates as its primary policy tool. The possible need for a “pause” on rates while the initial phase of balance sheet policy is implemented is likewise reduced.
Federal Reserve President Eric Rosengren has been at the forefront of advocating the idea, and he seems to have made headway in gathering support; since the May meeting, several other Committee members have cited its attractions in their speeches and remarks to the press.
But it also by design means a more active rather than passive management of the balance sheet. The FOMC would retain the option to assess and potentially alter the pace of assets being rolled off at each meeting – and in either direction, to scale up or reverse and resume QE if the economy falters and the Fed is facing the effective lower bound again.
Indeed that trade-off of a new policy initiative while retaining the option of reviewing and altering the plan along the way was crucial to achieving a consensus among the differing views within the Committee on both the open ended large scale bond purchases and the taper. That neither was altered is almost beside the point.
It is our sense there is yet to be a Committee-wide consensus on the scheme, whatever its attractions, and for the same reason there is no firm consensus yet on other key aspects of the Fed’s evolving balance sheet policy, be it a “larger” balance sheet retaining the current floor, or “reserve-abundant” operating system in which the overnight reverse repo facility features prominently, versus a return to a pre-crisis, minimalist balance sheet operating within a “reserve scarcity” framework.
At its core, the technical issues are all revolving around a more fundamental issue of how the FOMC’s current members envision the Fed’s role in operating future monetary policy and what sort of market footprint it should maintain going forward, whether the balance sheet will or should become a policy tool going forward, and if so, under what terms and conditions? And by default if not by design, there is the issue of what should the Fed’s future relationship be with Treasury and fiscal policy. These are big issues.
Some Committee members, whom we would refer to as the “institutional hawks,” argue for a balance sheet reduction on ‘auto-pilot,” in which once the amount of assets rolling off and the timing to end reinvestments is set, the process continues without changes or an active management to ensure the balance sheet truly returns to the background, with rates firmly defined as the primary policy tool.
We think this group is a minority within the Committee, but they may tend to be the most impassioned in their views and are likely to wield an out-sized influence during the period when a consensus on the balance sheet is being sought. And on that score, while Chair Janet Yellen may be willing to countenance a dissent or two on the timing to rate hikes, she will be seeking a full consensus and a unified Committee support on a decision so significant as the balance sheet and the Fed’s policy role going forward.
One last point we would add is that, while unspoken to date, there is no small degree of political anxiety driving the Fed’s ambitions to lock down its balance sheet policy before year-end. However it may evolve in getting to a consensus, it may ironically up-end the traditional definitions of hawk versus doves on the Committee through the year, as the arguments for a greater degree of flexibility on balance sheet policy could come to be seen as leaving the Fed vulnerable to ever greater political pressures down the road.