Fed Raises Rates, Lays Out Plan to Cut Balance Sheet

The central bank says it will hike again this year, but some analysts are skeptical

Federal Reserve Board Chair Janet Yellen. (Photo: AP) Federal Reserve Board Chair Janet Yellen. (Photo: AP)

The Federal Reserve on Wednesday raised rates 25 basis points to a range of 1% to 1.25%, as expected, and indicated there would be one more rate hike this year, but some analysts aren’t so sure.

That’s because in addition to the rate hike, the Fed laid out its plan to reduce its $4.5 trillion balance sheet, which is essentially another means of tightening monetary policy, at a time when economic growth appears to be slowing and inflation declining. The Fed indicated it could begin to implement the plan this year.

(Related: Gundlach: Even Odds of Another Rate Hike; Trump Being ‘Rope-a-Doped’)

Under the plan, the Fed expects to reduce the amount of its holdings of Treasuries and mortgage-backed securities by $10 billion a month — split 60/40 between Treasuries and mortgage-backed securities — raising the cap by $10 billion in subsequent quarters until reaching $50 billion a month.

“We  are now officially in the ‘Reverse QE’ era and it will be important for the market to prove it can digest the unwind of what many believe to have created a stock market and bond market runup,” says Brett Ewing, branch manager at First Franklin Financial Services in Tallahassee, Florida. He was referring to the quantitative easing policies the Fed adopted, buying securities, to boost an economy suffering from the financial crisis.

But Ewing questioned the ability of the Fed to unwind its balance sheet and raise rates while inflation is falling. “One of them has to give,” said Ewing.

He doesn’t expect the Fed will raise rates again this year if it also starts to unwind its securities holdings and there are no changes in fiscal policy, such as tax cuts, that have the potential to boost growth and increase inflation.

Roger Aliaga-Diaz, Vanguard Chief Economist, Americas, agrees. “We don’t anticipate inflation to rise meaningfully from current levels in the second half of the year, and believe the Fed will likely hold off implementation on any additional rate hikes — with a potential long pause through 2018,” said Aliaga-Diaza, in a statement.

The latest Consumer Price Index report, released just hours before the Fed meeting, showed prices falling 0.1% in May, which capped a 12-month rate at 1.9%, below the Fed’s 2% target. In addition, the government reported that retail sales fell 0.3% in May, its biggest drop in 16 months.

The Fed itself lowered its own inflation projections on Wednesday, to 1.7% for core personal consumption expenditures, its favored inflation gauge, from the 1.9% rate it had projected in March.

Referring to the PCE, Chris Gaffney, President of World Markets at EverBank, said, “The question is whether or not the slight pullback which we have seen recently will be temporary as many of the members of the FOMC believe. The ‘risk’ is that prices will continue to fall which would cause the FOMC to hold off on any future interest rate increases.”

The Fed's updated economic projections, based on the views of Fed board members and bank presidents, also included downward revisions for the unemployment rate to 4.3%, 4.2% and 4.2% for 2017, 2018 and 2019, from 4.5% in each of those years, and a drop in its federal funds rate projection for 2019 to 2.9%, from 3% previously. The Fed iterated its 3% projection for the longer run fed funds rate.

In her press conference following the release of the Fed’s policy statement and economic projections, Chair Janet Yellen said that Fed policymakers have some uncertainty about that 3% rate as well as the economic outlook and will adjust the fed funds rate accordingly. As she has said before, "Policy is not on a preset course.”

--- Check out Fed Surprises Financial Markets, Indicating 3 Rate Hikes Next Year on ThinkAdvisor.

 

 

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