The minutes of the Federal Reserve’s latest meeting revealed that there will likely be a further tightening of monetary policy. In a two-part plan, the Fed will begin by raising the Federal Fund’s overnight rate then it will start to reduce its reservoir of bond and mortgage-backed securities later this year. The second part of the strategy can be seen as a kind of substitute for the former.
Using this logic, rate hikes may be put on hold for the first part of 2018. US economic data will dictate the scope and pace of these monetary tools. As the Fed veer towards full employment, any concerns surrounding inflation will be promptly quenched as the Fed scuffle towards higher costs of borrowing.
Clutching onto the subject early in the meeting, the confluence of higher interest rates and paring of the balance sheet all depend on the path of the US economy. The members noted that economic stimulus must stay course and that there will be a ‘’gradual’’ increase of interest rates followed by a change to the Committee’s reinvestment of the balance sheet.
The projection for median rates in March held steady at three increases for 2017. The rate hike in June was within expectations of the Fed. With one rate hike allocated to each quarter of 2017 the target range is between 1.25 – 1.5%. Edging toward this target mark would be an undulated step towards normalisation of interest rate policy. With that, the Fed will turn its attention to the colossal $4.5 trillion balance sheet. As noted in the meeting minutes, this is the course set out for the Federal Reserve’s delicate departure from quantitative easing.
The Fed have noted that teasing the markets with ambiguous proposals is to be avoided. Instead a phased-out plan of reinvesting its holdings is more favourable and poses less risk to tamper with market volatility.
Inflation is the main barrier to this plan. The optimal level of 2% inflation has not been reached. Moreover, the path of inflationary pressures is muffled under the noise of Trump’s campaign proposals, which may not materialise. Additionally, productivity and consumer confidence remain subdued.
However, if the PCE inflation rate ticks up in April the Fed seem all too ready to step in to extinguish the overstimulation of the economy, ensuring that it remains behind the price curve.
The Fed are growing anxious about the high prices of a range of risky asset classes. If the risk was condensed and applied to just one asset class, the Fed could rationalise that the skewed risk allocation does not pose to threaten the US economy. Since there is a wider range of asset risk the Fed may respond with a tightening of monetary policy.
However, would higher interest rates diminish equity prices? Probably not. Here’s where the plot thickens. The Fed will have to weigh the benefits of decreasing equity prices with higher interest rates while risking the growth of the US economy with speedy and aggressive rate hikes.