The Fed Takes Another Step Toward Normalization

Two things that may affect its future course

This week, the Federal Reserve (Fed) voted to increase interest rates by another 25 basis points, marking the second of three forecasted rate hikes this fiscal year. Today’s hike was widely anticipated and had been priced into the market, despite weak domestic Q1 growth (1.2%[1]), which the Federal Reserve acknowledged in its communication. If the Federal Reserve had reversed course and decided not to go through with the hike, the market reaction would have been much more volatile, as it would have undermined investor confidence that the economy remains strong enough to continue with normalization of monetary policy. The fact that the dollar has declined and the yield curve has flattened (i.e., long-term interest rates have remained low while short-term rates have increased in recent months) mean that the market expects the Fed to be even more patient in its normalization.

The surprise to markets could come if the Fed decides to increase the pace of normalization sooner than expected. The answers to two key questions may provide important clues as to the future pace of normalization:

  1. When will the Fed start to proactively shrink its balance sheet? In today’s statement, the Fed indicated it would begin later this year to let some of its balance sheet portfolio run off. The balance sheet swelled beginning in late 2008, via implementation of quantitative easing (QE) in the midst of the financial crisis. This involved the large-scale purchasing of U.S. treasuries and mortgage securities in an effort to keep interest rates at record lows—ultimately, in hopes that increased lending would encourage growth. Fed Chair Janet Yellen announced the end of the bond-buying program in late 2014, but the balance sheet remains at $4.5 trillion due to reinvesting principal payments and maturing securities. Many have been expecting that the Fed will start to take action on the balance sheet at its December meeting; however, today’s statement indicates there is a possibly that the Fed may begin sooner. When and how the Fed proceeds could have wide-ranging market implications.
  2. Will Janet Yellen remain chair? It’s no secret that President Trump has not always seen eye-to-eye with Fed Chair Janet Yellen, whose four-year term ends on February 3, 2018. Trump frequently criticized Yellen while campaigning, and in April 2016, he even stated that he would “most likely replace her.” However, just a year later, in an April 2017 interview with the Wall Street Journal, it appeared that Trump’s attitude on Yellen had changed. Though President Trump has not yet announced whether he plans to reappoint Yellen, if there’s anything predictable about this administration, it’s that it is unpredictable. If a conservative nominee is named, a hawkish approach toward monetary policy could increase the pace of normalization, potentially sending shock waves through markets. Should Trump choose to replace Yellen, expect a nominee to be announced this summer.

While markets are convinced of the view that normalization will remain slow, patient, and predictable, that is by no means guaranteed. We will continue to watch the actions of the Federal Reserve and keep clients apprised of how it may affect portfolios.

[1] Source: Bureau of Economic Analysis, U.S. Department of Commerce

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