Why the Fed is likely to raise rates

The Federal Reserve is likely to forge ahead with plans to tighten monetary policy later on Wednesday despite a succession of poor inflation readings as it banks on continued strength in hiring.

Fed chairwoman Janet Yellen and her colleagues on the Federal Open Market Committee are widely expected to pull the trigger on a second rate increase this year, lifting the target range for the federal funds rate by a quarter point to 1 per cent to 1.25 per cent.

In addition, the central bank has been preparing to update a statement of its approach to “normalisation” of monetary policy. The new elements would cover its strategy for reducing the size of its $4.5 trillion balance sheet by phasing out the reinvestment of proceeds of maturing securities on its portfolio.

What will the Fed’s statement reveal?

Core inflation figures headed in the wrong direction in March and April, and hiring undershot analysts’ expectations in May, according to numbers released at the beginning of the month. Nevertheless, Ms Yellen and her fellow rate-setters have not given up on their expectation that America’s arrival at full employment will drive inflation back to the central bank’s 2 per cent target.

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The Fed said in its May meeting that most policymakers would back a rate increase “soon” if the economy stays on track. Barring a big change of heart this suggests a quarter-point rate increase is likely to be announced on Wednesday.

If the Fed moves, that should not mask the underlying concern among some policymakers about inflation’s stubborn refusal to accelerate – or for that matter wage growth that at 2.5 per cent in May was no higher than it was a year earlier.

There is, accordingly, a chance that the Fed will acknowledge the weaker price growth in its post-meeting statement even though it will not abandon its central case that inflation is heading back to 2 per cent. If inflation continues to disappoint in the second half, the calls from Fed doves for a rethink will grow.

Soft inflation numbers are unlikely to prompt a mass retreat by Fed policymakers from their March forecast that there will be three rate rises this year, including the move in March. But analysts will be watching the so-called dot plot of rate forecasts for any downward drift in 2018 and 2019.

What about the balance sheet?

This will be an important focus for markets. During the crisis the Fed not only cut rates to near zero, but also boosted its balance sheet by about $3.5 trillion by buying Treasuries and mortgage-backed securities. Its holdings now stand at roughly $4.5 trillion, including $2.5 trillion of Treasuries and $1.8 trillion of mortgage-backed securities.

The Fed expects to begin the ultra-gradual process of reducing that balance sheet this year. Policymakers have signalled that they may in this meeting be ready to update their principles and plans for balance sheet “normalisation” – although they could choose to wait until the release of the next set of minutes to publish the document.

Among the elements could be an affirmation that the Fed wishes to use short-term interest rates as its primary tool for steering the economy. Minutes from the Fed’s last meeting also said policymakers had backed a strategy of phasing out reinvestment of the proceeds of maturing securities. This would involve the Federal Open Market Committee announcing a set of steadily increasing caps on the amounts of securities that would be allowed to run off.

What are the big questions facing Yellen?

Balance sheet matters will feature prominently when she speaks to the press after the statement. The issues include: the timing or conditions under which policymakers envisage starting the balance sheet reduction; the size of the caps on the amount of securities that can run off; and the time it will take before the caps reach their final level.

On the first of these, the Fed has already said it would not start balance sheet reduction until the process of lifting interest rates is “well under way”. Lael Brainard, a Fed governor, has suggested that balance sheet reduction could start after the Fed funds rate range gets midway towards policymakers’ median projection for the long-run value of the Fed funds rate, which is currently 3 per cent.

That points to balance sheet reduction kicking off after a further rate increase that could come as soon as September. But the risk of a market-shaking debt ceiling showdown this autumn could easily delay matters.

A further critical question is where the Fed’s “normalised” balance sheet will land after it has pared back its asset holdings over a period of years. Most economists expect it to be much larger than before the crisis, but the Fed has given no formal guidance.

The ultimate size will depend on the mechanism the Fed decides to use to set future rates and the quantity of reserves commercial banks want to hold at the central bank. The Fed may, therefore, have to feel its way towards the ultimate balance sheet size by gauging banks’ demand for reserves. Governor Jerome Powell this month cited Fed scenarios involving reserves ranging from $100 billion (€89.2bn) to $600 billion (€535.2bn) or as much as $1 trillion. – Copyright The Financial Times Limited 2017