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Fed to Begin Balance Sheet Cuts; Hints Rate Hike Up Next

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The Federal Reserve announced Wednesday it will begin to shrink its $4.5 trillion balance sheet in October by $10 billion a month, split 60/40 between Treasuries and mortgage-backed securities. 

That’s the amount of maturing securities it will no longer reinvest in its gradual effort to undue the quantitative easing policies it adopted to address the financial crisis and Great Recession of 2007-2008.

The Fed refrained from hiking short-term rates again but suggested it will raise rates one more time before year end, with 12 of 16 policymakers supporting such a move. Until recently, financial markets seemed bent on expecting no more hikes this year, but that appeared to change in recent days with even odds given for another increase before year end.

Financial markets had little reaction to the Fed’s announcement, though the Dow Jones industrial average and S&P 500 index lost some points and long-term bond prices fell slightly as their yields rose. The Dow, however, ended the session with slight gains.

The market was positioned for a dovish statement and didn’t get it,” said Kathy Jones, senior vice president and chief fixed income strategist for the Schwab Center for Financial Research. “The biggest response so far has been in the dollar’s move up. There was some steepening of the yield curve and 10-year treasuries are testing the 2.30% resistance level.”

“Equities are still trying to assess the implications,” said Quincy Krosby, chief market strategist at Prudential Financial, following the Fed’s announcement. “Broadly speaking there remains an ongoing tug of war between those who think the economy is still too weak to handle another rate hike versus those who say that financial conditions and a strengthening global economy warrant the move towards rate normalization.”

The Fed’s latest economic projections, known as its dot plot — comprising the projections of each policymaker — shows expectations for a slightly stronger economy this year: 2.4% GDP growth, up from 2.2%, but lower inflation, with core PCE rising 1.5% by Q4, down from 1.7% previously projected, and unemployment unchanged at 4.3% in the fourth quarter.

Longer term, policymakers are expecting an even lower unemployment rate by Q4 2018 and Q4 2019 and lower core inflation than previously forecast, and its long-run (beyond 2020) neutral level for the federal funds rate fell to 2.75%, down from 3%.

Lisa Hornby, U.S. fixed income portfolio manager at, Schroders, said the Fed’s assessment of economic conditions seems “marginally more hawkish” given the expectations for another rate hike this year.

She and other strategists and economists noted the Fed’s statement reference to hurricanes Harvey, Irma and Maria as having only a transitory, nonmaterial impact on the economy despite the devastation they wrought.

“The outlook on growth and the labor market remains positive,” said Jim O’Sullivan, chief U.S. economist at High Frequency Economics. “While officials lowered somewhat their 2018-’19 core inflation projections, their tone and message did not change; they continue to project a return to a 2% trend.”

“The Fed’s inflation projections have hardly budged and they are a bit more optimistic on the near term growth outlook,” said Brian Coulton, chief Economist at Fitch Ratings. “We continue to expect another rate hike in December.”

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