September rate unchanged: The beginning of quantitative tightening? Not quite
Sep 22, 2017, 13:59 PM
The Federal Reserve held the federal funds rate at its current target range of 1.0%-1.25% and appears likely to make one additional rate hike this year.
Despite the Fed’s three 0.25% interest rate increases since December 2016, cap rate changes have been muted as long-term interest rates have actually decreased.
The Fed has indicated it will begin unwinding its balance sheet in October, after Treasury and agency redemptions start to increase.
With Federal Reserve Board Chair Janet Yellen’s reappointment in question, Vice Chairman Stanley Fischer scheduled to resign in October and three open board of directors’ seats, the FOMC will likely look very different in 2018. The impact of these changes won’t be known until appointments are made to fill these openings.
The Federal Reserve maintained the target range for the federal funds rate at 1.0%-1.25% today. Having made three 0.25% increases since December 2016, the Federal Open Market Committee (FOMC) is expected to make one additional increase in December. Slower growth in the core CPI and core PCE price index (core personal expenditures prices, excluding food and energy) might cause the Fed not to make any further rate increases this year, despite the labor market’s flirting with full employment and the expectation that economic fallout from hurricanes Harvey and Irma will shave between 0.4 and 0.8 percentage points from Q3 GDP growth. The August data showed a slight uptick in inflation as the impact of Harvey pushed up gas prices. Hurricane effects should firm up used-car prices too, which had been pulling down the inflation numbers.
The underlying trend in economic growth—steady at 2% in recent years—should continue, as the economic damage from the hurricanes is likely to be transitory. Reconstruction efforts should boost economic activity beginning in Q4 2017, which is when the market now expects the Fed to hike rates (a 52% probability according to CME Group’s FedWatch).
In addition to generally good underlying economic conditions, commercial real estate fundamentals remain strong—particularly in the industrial sector—and a rebound in economic growth in Q4 should keep them healthy for at least the first half of 2018. Cap rate increases have been relatively modest as the long-end of the curve has decreased in 2017. The flattening of the curve is a concern, but the halt in short-term increases combined with the unwinding of the balance sheet should steepen the curve going forward. Most of the very modest cap rate softness in 2017 is related to fundamental concerns about certain market/asset types being near the top, in addition to some secular concerns about retail.
Although the Fed was expected to maintain rates, markets were looking for further clues on how the Fed plans to unwind its balance sheet. Despite three rate hikes since December 2016 and the Fed’s intention to initially unwind its balance sheet, the bond market has been calm, with the 10-year Treasury falling to a low of 2.05% as of Sept. 8. Likewise, the Dow has rallied 11.5% so far this year, while the trade-weighted dollar has sunk 10.6%. Overall, there has been none of the hysteria that occurred during the “taper tantrum” in May 2013, and for good reasons.
The Fed has telegraphed its unwinding process and has emphasized that it will be gradual, thus allaying investor concerns to some extent. The balance sheet roll-off will gradually increase to a maximum of $50 billion per month ($30 billion in Treasurys and $20 billion in MBS). However, a mere $362 billion or 14% of total Treasurys mature over the next year, and the run-rate for the wind-down process won’t hit $30 billion until September 2018. Therefore, until September next year, Fed reinvestment will still be greater than redemptions. It is only between 2018 and 2022, when redemptions are scheduled to total $1.14 trillion (46% of total Treasurys), that any material impact to bond markets may occur.
As for MBS, the impact from the wind-down process may take longer, as 99% of the $1.78 trillion in MBS will mature in more than 10 years (assuming mortgage borrowers do not pre-pay their loans, which is highly unlikely). New York Fed President William Dudley has stressed that the total balance sheet would be reduced by $1 trillion to $2 trillion—significantly less than the $3.7 trillion purchased between 2007-2014. Therefore, the balance sheet would still be much larger than it was before the 2008 recession. The larger balance sheet isn’t surprising or unhealthy, since the U.S. economy and money supply have both grown significantly in the past decade.
Lastly, with little clarity on the reappointment of Janet Yellen as Federal Reserve Board chair, and Vice Chairman Stanley Fischer—an advocate of tighter monetary policy—scheduled to resign in October, the makeup of the FOMC could look very different next year. With the Trump administration pushing for greater fiscal flexibility, the FOMC could well look a lot more dovish.