Most Participants Expect Normalization to Begin Later this Year, Include Both Treasurys and Agency MBS
by Craig Dismuke, Dudley Carter
The Minutes from the FOMC’s mid-March meeting offered no surprises on the outlook but did provide some insight into the Committee’s mindset on normalization of its balance sheet.
March Meeting Refresher: As a refresher, the FOMC voted to raise the federal funds range by 25 basis points on March 15 to 0.75%-1.00%, marking the third rate increase of the current rate cycle. The decision prompted a dissent from Minneapolis Fed President Kashkari. The Statement included a modest upgrade to the economic assessment as a result of somewhat firmer business investment. The inflation language was changed to acknowledge energy-driven increases in headline measures but caveated that core inflation remained somewhat below the Committee’s target. In the projection materials, the infamous dot plot showed no change to the median dot for this year or next and the economic forecasts were only marginally different. Chair Yellen’s press conference was routine but she acknowledged the Committee had begun discussing the process of normalizing the balance sheet but had made no final decisions.
The Nuts and Bolts: As expected, the Minutes offered little excitement on the economic outlook. Similar to the tone in the Statement, the consumer is expected to continue as the driving force of growth but “recent momentum in the business sector had been sustained over the intermeeting period.” There is a general consensus on the status of the labor market. The Minutes showed, “Nearly all participants judged that the U.S. economy was operating at or near maximum employment,” but there is divergence about the level of slack that remains. There is greater divergence on the outlook to inflation. Several participants are still waiting on sustained inflation near the 2% target while several other said the Committee has met its mandate. Both sides agree inflation will be key to monitor going forward. While the Committee sees the risks as “roughly balanced overall”, the general tone towards risk seems more upbeat.
Markets Want to Know: Markets were looking to the Minutes for any insight into two primary themes:
When will the Fed begin to normalize the balance sheet and in what manner will that process be implemented?
The Minutes from the January/February meeting included a single mention about normalization by saying participants had agreed to begin discussing what conditions would warrant changes to the reinvestment policy, what those changes would look like, and how they would be communicated to the public. At the March meeting, Chair Yellen said the topic had been further discussed. Since the March meeting, most every Fedspeaker has given his or her two cents on the normalization process. The March Minutes provided some further details on the topic of normalization.
The Minutes showed, “participants agreed that reductions in the Federal Reserve’s securities holdings should be gradual and predictable, and accomplished primarily by phasing out reinvestments of principal received from those holdings.” This agreement came after discussion of “the potential benefits and costs of approaches that would either phase out or cease all at once reinvestments of principal from these securities.” As to when, “most participants anticipated that gradual increases in the federal funds rate would continue and judged that a change to the Committee’s reinvestment policy would likely be appropriate later this year.” Once normalization has begun, “participants generally preferred to phase out or cease reinvestments of both Treasury securities and agency MBS.” “Nearly all participants agreed that the Committee’s intentions regarding reinvestment policy should be communicated to the public well in advance of an actual change,” and “several participants indicated that…it would be desirable to also provide more information to the public about the Committee’s expectations for the size and composition of the Federal Reserve’s assets and liabilities in the longer run.”
With the Fed keeping its median expectation for a total of three hikes this year, why the all-of-a-sudden push for March? Where might the next two hikes fall within the remaining eight months of the year?
Treasurys sold off in the weeks leading up to the March meeting after a furor of hawkish Fedspeak agitated markets and turned the priced-in probability of March hike from less than a coin flip to a dead certainty. Markets feared such an urgent push from both sides of the aisle meant the Fed feared being behind the curve and was looking to pick up the pace of tightening. However, this theory was debunked by the nearly unchanged dot plot. So with three hikes still the consensus at the Fed, markets are anxious to know when the next two might come. The March Minutes showed no signs of fear of being behind the curve and no signal to a particular meeting.
Per the Minutes, “Members generally noted that the increase in the target range did not reflect changes in their assessments of the economic outlook or the appropriate path of the federal funds rate, adding that the increase was consistent with the gradual pace of removal of accommodation that was anticipated in December, when the Committee last raised the target range.” There was no signal to any particular meeting and the Committee “reiterated that they expected that economic conditions would evolve in a manner that would warrant gradual increases in the federal funds rate.”