The Federal Reserve held open the possibility of a further increase in short-term interest rates this year as it threw its crisis-era stimulus programme into reverse, in a mark of optimism that inflation will emerge from this year's sluggish pattern.
The US central bank, chaired by Janet Yellen, on Wednesday said it would start paring back its multi-trillion dollar balance sheet in October, even as it kept the target range for its key rate at 1-1.25 percent. While acknowledging the damage that has been afflicted by the recent hurricanes, most policymakers stuck with forecasts for another rate rise in 2017—most likely in December—as well as three further increases in 2018.
Signs of a global upswing have helped spur the Fed to lift rates twice this year and prepare to pull back its Quantitative Easing programme, as falling unemployment and steady growth reduce the need for emergency levels of monetary support.
Still, the central bank's policy committee remains divided over the urgency of further tightening given a string of poor inflation figures. The Consumer Price Index jumped in August, yet that follows five months of weak readings and is unlikely to dispel all of the worries about soggy price growth among the Fed's officials.
In a signal of their caution over the economy's longer-term potential, officials brought down their median expectation for official rates in the long term, cutting it from 3 percent to 2.8 percent. That chimes with a longstanding view among many investors that the Fed will not be able to lift rates very far; going into Wednesday's announcement markets saw only a 50-50 chance of two rate increases by the end of next year.
In a statement accompanying its decision, the Fed gave a broadly optimistic take on the current economic picture, saying business investment has picked up even if inflation has been running below target. The Fed acknowledged the recent hurricanes had inflicted "severe hardship" but insisted that past experience suggested they would not materially affect the course of the national economy. Any boost to inflation from the storms was likely to be fleeting.
In a unanimous decision, the Fed said it would start normalizing its balance sheet from October. The move by the world's most influential central bank to start paring back its asset holdings marks a pivotal moment as monetary policymakers around the world gingerly retreat from the support operations they put in place during the worst financial meltdown of modern times.
The Fed more than quadrupled the size of its balance sheet to $4.5tn by purchasing treasuries and mortgage-backed securities (MBS) under Ben Bernanke, the former chairman. The European Central Bank has recently been indicating it will wind down its asset purchase scheme as it responds to firmer growth in the euro area, while the Bank of England has suggested it could lift short-term rates this year in response to higher inflation risks.
At the moment the US central bank reinvests the payments it receives on the portfolio of government bonds and mortgage-backed securities it amassed during the crisis, keeping its overall holdings steady. When the balance sheet rundown starts the Fed will gradually phase out those reinvestments.
The Fed's plan involves setting a steadily increasing set of caps: payments will only be reinvested to the extent they exceed the caps. The caps will initially be set at $6bn per month for treasuries and $4bn for agency MBS. They will be steadily lifted in three-month intervals until they peak at $30bn for treasuries and $20bn for MBS, in about a year's time. The initial cap will first be applied to holdings of treasuries on October 31, while an announcement will be made on MBS holdings on October 13.
In accompanying forecasts, policymakers once again had to reduce their estimate for inflation in the near term following the recent disappointments.
They cut their estimate for core inflation at the end of 2017 to 1.5 percent from 1.7 percent in June, with inflation excluding food and energy not returning to target until 2019. Unemployment is now seen dropping to 4.1 percent next year and in 2019, compared with 4.2 percent previously. The longer-run unemployment rate remained at 4.6 percent. At 2.4 percent, the estimate for growth this year was somewhat stronger than June's outlook of 2.2 percent.
The median forecast for the midpoint of the Fed's interest rate target range was left at 1.4 percent in 2017, unchanged from their June outlook. The prediction was centered at 2.1 percent in 2018, also unchanged. The 2019 prediction was 2.7 percent compared with 2.9 percent earlier, and the new 2020 expectation was 2.9 percent.
The reduction in the long-run forecast to 2.8 percent suggests policymakers have become even less optimistic about the growth and inflation outlook further down the road, meaning rates will need to be lifted less than previously anticipated.
Markets have appeared largely unconcerned by the prospect of the Fed's retreat from money-printing; two increases in short-term rates this year coupled with signals of a reduced balance sheet have done little to tighten financial conditions in the US thus far. But major changes on the board of the Fed—where Donald Trump has the possibility of installing as many as five new governors—could yet overturn the ultra-predictable strategy that Ms. Yellen is setting in train.
In addition, the outlook for bond yields could be swung by the possibility of fiscal loosening by the Republican-led Congress. In the Senate, lawmakers are edging towards a budget resolution that could pave the way for tax cuts amounting to as much as $1.5tn over 10 years.
This article was originally published by the Milwaukee Business Journal.