No surprises on interest rates. A mild surprise on reducing the Federal Reserve’s balance sheet.
As expected–the Fed Funds Futures market was giving odds of 99.6% that there would be a 25 basis point interest rate increase–the Federal Reserve raised interest rates for the second time in 2017 and for the third time in six months. The 25 basis point increase took the federal funds rate to 1.00% to 1.25%.
However, the Fed’s willingness of talk about its plans to wind down its $4.5 trillion balance sheet came as somewhat of a surprise. Fed watchers have assumed that the central bank would soon start to reduce its portfolio of Treasury debt and mortgage-backed securities, but they were inclined to believe that the Fed wouldn’t give any details until later in the year. Instead the Fed said today it would gradually reduce its holdings by decreasing its reinvestment as assets mature. Reinvestment will be subject to caps–no reinvestment until maturing securities top that level–and the caps will gradually rise during the plan. The caps will start out at $6 billion a month for Treasuries and $4 billion a month for mortgage-backed securities. In other words, the Fed will reduce its balance sheet by $10 billion a month to start. The end point to that reduction will be “a level appreciably below that seen in recent years but larger than before the financial crisis; the level will reflect the banking system’s demand for reserve balances,” the Fed wrote. The reduction plan will begin sometime later in 2017. The cap will rise by $10 billion every quarter until the balance sheet is declining by $50 billion a month.
The Fed cited continued strength in the labor market as one reason to raise interest rates. However, the Fed did lower its estimate for 2017 core inflation to 1.7% from 1.9% while upping its target for 2017 GDP growth to 2.2% from 2.1%. The Atlanta Fed’s GDPNow forecast for second quarter GDP rose to 3.2% from 3.0% on June 9.
The Open Market Committee’s dot plan showed that the median expectation of participants in today’s meeting was for a target range on the Fed Funds rate at the end of 2017 of just 1.25% to 1.50%, implying just one more interest rate increase in 2017. The median projected range for 2018 was 2.0% to 2.5%. That slow an increase in interest rates should make the stock market very happy.
