Fed hikes and points to more, future balance sheet changes slow & steady - ING

Analysts at ING explained that they delivered a 25bp hike and suggest 3% remains the long run goal. 

Key Quotes:

"They also provide more details on balance sheet adjustment, which will be very slow with the economy set to grow into the bloated balance sheet to a large extenet.

The Federal Reserve has delivered a 25bp rate hike, as widely expected, and indicates that it continues to think another rate rise is probable before year-end. The “Fed dots” diagram shows that FOMC members expect the fed funds rate to be 1.25-1.5% for end 2017 before rising to 2-2.25% in 2018 with the longer run figure remaining 3%. These are the same as their last forecast update in March. There was one dissenter at this meeting – Neel Kashkari who opposed the rate move.

The market believes this is too high with fed funds futures suggesting another rate rise this year has barely a 50:50 chance. There is little further policy tightening priced in for 2018. Nonetheless, in the accompanying statement the Fed reiterated that they continue to believe “economic activity will expand at a moderate pace” with the risks to this assessment appearing “roughly balanced”. They do acknowledge the recent softness in inflation stating that it will “remain somewhat below 2% in the near term, but [will] stabilize around 2% over the medium term”. This positive assessment is borne out in their economic forecasts with 2017 GDP revised up a tenth of a percentage point to 2.2% while 2018 and 2019 were left unchanged. Unemployment forecasts were lowered, while inflation was expected to average 2% in both 2018 and 2019.

With little sign of tax reform and fiscal stimulus on the horizon and inflation rates declining rather than rising, markets will remain sceptical on the Fed’s assessment of the likely path of interest rates. We are still predicting an interest rate rise in September, but this will require further evidence that labour market tightness is generating higher wage growth.

Additionally, we have more details on the Fed’s balance sheet reduction plans. They state the Fed expects “to begin implementing a balance sheet normalization program this year, provided that the economy evolves broadly as anticipated”. In a supplementary document they confirm they will decrease the reinvestment of assets they hold. In terms of Treasuries they anticipate a cap of $6bn per month, increasing in steps of $6bn at 3M intervals over 12 months, until it reaches $30bn. For agency debt & MBS it will start out with a cap of $4bn, rising by $4bn every three months until it reaches $20bn in 12 months. The FOMC suggest these caps will remain in place until the Fed are holding “no more securities than necessary to implement monetary policy efficiently and effectively”.

Given the Fed’s balance sheet is $4.5 trillion this is a very cautious approach, which is understandable given the experience from the “taper tantrum”. This pace of reduction indicates that the Fed is happy for the economy to effectively grow into a large Fed balance sheet, reducing the need for them to offload assets. This is consistent with the Fed’s assertion that “changing the target range for the federal funds rate is the primary means for adjusting the stance of monetary policy”. Unsurprisingly, the US Treasury market is reacting positively to this news."