Fed leaves rates on hold and balance sheet reduction is coming soon

Fed Announcement

No surprises from the US Federal Reserve (Fed) with interest rates being left unchanged at the meeting last Wednesday. The statement contained some tweaks in wording with job gains now upgraded to “solid” and inflation is noted as “running below 2%”.

Meanwhile, balance sheet reduction (the unwinding of quantitative easing) is now expected to take place “relatively soon” for which read September.

Inflation poised to head lower

Investors saw the statement as dovish which probably stems from the inflation comment which contained no reference to temporary factors depressing the rate.

Consumer price inflation is likely to head lower in coming months and, whilst the core rate should stabilise, this will make further Fed tightening more difficult.

Market expectations are for the next rate rise to come in December once balance sheet reduction is underway.

The combination of balance sheet reduction and low inflation suggests there may not be another rate hike in 2017

Will the balance sheet unwind cause volatility?

However, this assumes that balance sheet reduction goes smoothly. We would note though that whilst the Fed plans to start slowly, the process picks up pace at a rapid rate. From an initial $10 billion per month the rate of unwind rises to $50 billion per month in just over a year.

In the absence of any guidance from the Fed as to where the balance sheet will end up, forward-looking markets could become concerned at the impact on liquidity and yields.

Greater financial market volatility would then cause the Fed to pause the unwinding of its balance sheet and probably defer further tightening.

Further rate hike this year looks unlikely

The combination of low inflation and balance sheet unwind suggests that we will not see another rate rise this year. Further tightening will then depend on inflation picking up and some fiscal boost. We expect both, but this will probably not be apparent in the data until later in 2018.


The article above was first published by Schroders on 27th July 2017.