Barclays March FOMC minutes :

We now expect balance sheet reduction to begin in December

Balance sheet reduction later this year is now part of the Fed’s plan. To our surprise, the minutes to the March meeting contained extensive discussion on balance sheet policies. We had expected this discussion to take place at the June FOMC meeting, with subsequent deliberations communicated around the timing of the annual Economic Symposium at Jackson Hole in August. However, the committee moved quicker than we anticipated, and staff weighed in with various alternative scenarios during the March meeting. The desire to signal sooner than later is likely a function of the committee’s wish to avoid adverse market reactions. Communicating early – and often – could have been seen as the best remedy to avoid a 2013 “taper tantrum” reaction from markets.

The main points from the minutes regarding balance sheet policies, as we see them, are :

  • Participants reaffirmed the approach to balance sheet normalization articulated in the Committee’s Policy Normalization Principles and Plans announced in September 2014;
  • Participants agreed that any reduction in securities holdings should be “gradual and predictable” and accomplished
    primarily by phasing out reinvestments of principal received from those holdings;
  • Nearly all participants preferred that the timing of a change in reinvestment policy depend on an assessment of
    economic and financial conditions, as opposed to a quantitative target on the level of the federal funds rate or a
    qualitative assessment of economic conditions and risks; and
  • Most participants anticipated that a change to the Committee’s reinvestment policy would likely be appropriate later
    this year if the Fed’s outlook was realized.

In regard to the usage of the balance sheet policy versus interest rate policy, the minutes indicate that the committee retains the view that the interest rate policy remains the primary instrument for monetary policy and that the asset purchases should be used only “if substantially adverse economic circumstances warranted greater monetary policy accommodation than could be provided by lowering the federal funds rate to the effective lower bound.” That said, “some participants” said it would be appropriate to “restart reinvestments” (eg, refrain from further shrinkage in the balance sheet) if the economy “encountered significant adverse shocks that required a reduction in the target range for the federal funds rate.”

We change our call for balance sheet reduction to begin in December. Altogether, in light of the extensive discussion in the minutes about balance sheet policy, including the clear signal that the committee sees balance sheet reduction later this year as warranted under the existing outlook, we change our call on the timing of the end of reinvestments and the path of interest rate increases in 2017. We now expect the committee to raise the target range for the federal funds rate two more times this year, in June and September, and announce balance sheet runoff at the December FOMC meeting. The reduction in the balance sheet, in our view, will occur through the reduction in holdings of MBS and Treasuries simultaneously as principal reinvestments are gradually phased out. Our outlook now includes four policy actions this year, not three as indicated in the median path of the funds rate as specified in the Summary of Economic Projections, since gradually reducing the size of the Fed’s securities holdings should put upward pressure on the term premium and represent a further tightening in financial market conditions.

We stress that ending reinvestments and reducing securities holdings may be part of the Fed’s policy plans, but history has shown that its plans can get disturbed. Twice in previous years, its plans for regular removal of accommodation were thwarted by adverse financial market conditions and evidence that the economy was further from full employment than previously thought, among other factors. That said, the Fed’s outlook for the US economy and assessment of the balance of risks is similar to our own; if it sees this outlook as warranting balance sheet runoff later this year, then it warrants inclusion in our own baseline, given the symmetry of views.

The best laid plans of mice and men often go awry. A risk to our view is that the Fed is announcing its intentions on balance sheet policies earlier that it otherwise might have done based on economic conditions alone. Given our expectation for significant turnover within the Board of Governors, we think this may have been an influencing factor. We foresee a significant amount of change in the board and believe only Governor Powell will remain on the committee past mid2018. We believe Chair Yellen and Vice Chair Fischer will depart the board when their terms end in early and mid2018, respectively, and we expect Governor Brainard to announce her resignation around the same time. The board currently has three vacancies with the departure of Governor Tarullo and two unfilled vacancies. We believe the committee may desire to lay out its plans for the balance sheet and start the process of balance sheet reductions before the current leadership leaves, thereby handing over a complete set of interest rate and balance sheet policies to the incoming leadership on the FOMC, similar to the transition between Chairman Bernanke and Chair Yellen during the tapering of asset purchases. The risk is that the timing of board turnover and leadership changes are somewhat fixed in calendar time, and the evolution of the economy may not fully cooperate, delaying balance sheet runoff into 2018 or beyond.

An economy on solid grounds led the FOMC to hike in March
The FOMC decided to increase the target rate at its March meeting, indicating it feels sufficiently comfortable with the progress made so far on the economy and toward its dual mandate. More specifically, the minutes show that the committee perceives the economy as still expanding at a robust pace and sees many of the factors driving the softness in Q1 activity as transitory. In addition, although participants’ expectations of some form of fiscal stimulus have been pushed out somewhat compared with the previous minutes, the FOMC still expects expansionary fiscal policy and to push the balance of risks on the upside. Regarding labor markets, the minutes expressed confidence that they are operating at or near full employment. Although the FOMC did not declare victory on its inflation mandate yet, it did nod to the fact that it continued to firm gradually. Finally, financial conditions were a significant factor supporting its move to hike rates in March, with a number of participants remarking that changes in financial conditions “posed upside risks to their economic projections” if they provided more stimulus to spending than they currently anticipate.

Marketing communication : This document has not been developed in accordance with legal requirements designed to promote the independence of investment research and its author(s) is/are not subject to any prohibition on dealing in the relevant financial instrument ahead of the dissemination of the marketing communication.

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