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Tomorrow the Fed is expected to reveal details of how and when it will begin to wind down its $4.5 trillion balance sheet.

The US Federal Reserve’s FOMC begins a two-day monetary policy meeting today. This will conclude tomorrow at 19:00 BST with the release of a statement, notice of any change to the fed funds rate and the quarterly Summary of Economic Projections. This will be followed half an hour later by a press conference held by Fed Chair Janet Yellen.

These quarterly meetings are always highly anticipated primarily due to the FOMC’s updated economic projections. This is when all members of the committee (not just those voting on the fed funds rate itself) offer up their forecasts for GDP growth, unemployment, inflation and interest rates. These forecasts cover 2017, 2018, 2019 and longer term and include the notorious “Dot Plot” which has proved so important in helping market participants to assess whether the FOMC is hawkish or dovish at any particular time.

But there’s another aspect to this meeting which looks likely to overshadow any changes to the FOMC’s forecasts. Tomorrow the Fed is expected to reveal details of how and when it will begin to wind down its $4.5 trillion balance sheet. Before the financial crisis the Fed’s balance sheet stood at around $900 billion. But the US central bank has no intention of taking it back to these levels. Instead the Fed is aiming to reduce it to around $2-2.5 trillion. It will do this by allowing a small proportion of bonds to mature each month without reinvesting the proceeds. Back in June the Fed revealed that it would start with reductions of $10 billion a month and raise the amount quarterly until it reached $50 billion a year later. The programme is expected to begin next month. So a $2 trillion reduction even at the higher $50 billion per-month rate suggests a wind-down period of around four years. This sounds cautious enough. However, in just the same way that this form of quantitative easing had never been tried before, it follows that no one has ever attempted to reduce it either. This is causing some concern amongst central bankers, investment bankers, politicians, economists, and, most importantly, investors.

Meanwhile, it now looks as if the Fed will hold off from raising rates further until it’s had time to assess the success (or otherwise) of its balance sheet reduction programme. Consequently, a significant number of analysts have pushed out their forecasts for the next hike to summer 2018. Despite this, the CME’s FedWatch Tool suggests there’s a 57% probability of a 25 basis point hike this December. This is up sharply from 23% less than two weeks ago. We’ll see if the FOMC agrees when we see the updated “Dot Plot.”

It’s worth remembering that Janet Yellen indicated in July that the Fed could be closer to its interest rate target, or neutral policy stance, than the market was then anticipating. This led to a repricing of the Fed’s objective to 1.75/2.00% from around 3.00% previously. At the same time, Dr Yellen emphasised the importance that the FOMC placed on boosting inflation. This was significant as annualised Core PCE (the Fed’s preferred inflation measure) has been trending downwards since the beginning of the year and, at 1.4%, is currently well short of the Fed’s 2% target. This suggested that the US central bank was considerably more dovish than previously thought. So there’s going to be a stack of information to take in tomorrow evening. This has the potential to shift markets sharply - particularly if the Fed appears more hawkish than expected. But if it keeps to the path sketched out over the summer, the dollar should continue to weaken and once again take the EURUSD back up above 1.2000 again.


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Posted by David Morrison

Category: PM Bulletin

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