The Fed’s policymakers meet this week, and handicapping what they’ll do is as avid as March Madness bets. The diff: Much more money is at stake with the Fed.
When the Federal Reserve’s Federal Open Market Committee reveals its latest thinking (or some of it) on Wednesday, many Wall Street prognosticators believe the FOMC will announce an end to its short-term interest rate hikes and to its balance sheet reduction.
Certainly, a lot of the speculation already is priced into capital markets. Fed board members have been making dovish sounds in public. But this Fed is not prone to surprise—and Fed Chair Jerome Powell has learned to guard his tongue better. Last year, stray Powell remarks that the Fed would proceed on auto-pilot to keep raising the benchmark federal funds rate, which affects short rates, convulsed the markets.
On Wednesday, the Fed will issue a statement by the committee and Powell will hold a news conference.
Here’s what may, if the savants are right, happen:
The Fed will pronounce the rate-hike regime is over. Starting in 2015 and increasing in tempo through last December’s meeting, the Fed has raised the benchmark rate nine times (once each in 2015 and 2016, three times in 2017, and four last year). That lifted the rate to a current band of 2.25% to 2.5%, from near-zero.
All along, the plan had been to move short rates back to their usual levels, a process called “normalization.” That is around 5%, although the rate in this century has been more like 3%. Many argue that the “natural rate” is lower nowadays because of enhanced globalization of finance, which means more foreigners are buying US bonds.
The Fed’s original hope was to raise the rate sufficiently high so it would have plenty of room to lower it again as a stimulus measure, come the next recession. But that wish seems to have withered.
The wagering is that the Fed will do nothing this year, according to the futures market run by CME Group. And indeed, by year-end, almost a quarter (23.5%) of the betting is that the Fed will cut by a quarter percentage point, which is in keeping with the general expectation that a recession will hit in late 2019 or 2020.
The Fed balance sheet will stop shrinking later this year. Over the past four years, the Fed has been unwinding its vast hoard of Treasury and mortgage bonds, in a bid to increase long-term rates. This move reversed the central bank’s quantitative easing program begun in response to the financial crisis and the Great Recession—where the Fed bought enormous sums of these bonds to lower long rates and stimulate the economy.
Before the crisis, the Fed’s balance sheet was only $800 billion. At its height, the count was $4.5 trillion. Lately, the Fed has been letting about $50 billion of this paper mature, and its holdings now are around $4 trillion. Many expect the Fed will say it will stop this later in 2019, letting the balance sheet settle at around $3.5 trillion to $3.7 trillion.
A shift in what bonds the Fed holds. With the once-devastated housing market restored, though it’s nothing like it was before, the Fed would let the mortgage bonds (a.k.a., mortgage-backed securities) roll off and concentrate on owning Treasuries. Plus, it would move more into shorter-term Treasury bills. Reason: To give it more flexibility, as these obligations mature much sooner than the long bonds.
The Fed by law must buy Treasuries at auction, when they are newly issued. But there’s a quirk in the law that would allow the Fed to buy T-bills in the open market; If it uses proceeds from mortgage bonds’ maturing, it can foray away from the auctions and expand its sway.
The Fed still has some options once a recession appears. Likely, its response will be to buy more bonds, as it has less of a range to lower interest rates.
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