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Fed Expected to Hold Rates, Announce Tapering and Offer 'Transitory' Dot Plot

EconomySep 20, 2017 10:53AM ET
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© Reuters. Markets focus on Fed dot plot with very short shelf life – The Federal Reserve is widely expected to leave interest rates unchanged at its current range of 1.00% to 1.25% in its announcement at 2:00PM ET (18:00GMT) on Wednesday and also reveal its plans for the winding down, or tapering, of its asset purchases in order to begin, likely in October, the reduction of its $4.5 trillion balance sheet.

With no changes in rates priced in at 100% and the general plan for tapering having being laid out by the Fed itself in June in what San Francisco Fed president John Williams defined in August as the “the most telegraphed thing in the history of central banks”, markets are left to focus on factors related to future policy moves at Fed chair Janet Yellen’s press conference at 2:30PM ET (20:30GMT).

Tapering to up pressure on bond yields

The tapering plan already laid out by the Fed was to shrink the balance sheet by only $10 billion a month divided into around $6 billion in Treasuries and $4 billion in agency debt and mortgage-backed securities (MBS) with the increase being made in similar amounts at three-month intervals until the reduction in repurchases reached a total of $50 billion, or $30 billion in Treasuries and $20 billion in MBS.

Estimates of where the Fed plans to take its balance sheet range from about $2 trillion to $3 trillion, suggesting a gradual pace of reduction that will take years to complete and would allow the Fed flexibility to adjust their decision based on economic developments.

Compared to the current $4.5 trillion, where it has stayed since hitting that amount in late 2014, the Fed\'s portfolio was closer to $900 billion before the 2007-2009 financial crisis.

According to Goldman Sachs, the current balance sheet ballooned to an equivalent of 23% of U.S. gross domestic product, compared to just 6% of GDP prior to the crisis.

It is the central banks’ hope that their intention was sufficiently transparent and that the amounts are both small and gradual enough so as to not wreak havoc in the markets.

Still, Goldman predicts that U.S. Treasury yields will still rise by about 20 basis points in the year following the beginning of the program with a further gradual increase as the tapering continues.

Stubbornly soft inflation

As the Fed continues to move forward with policy normalization its members have been faced with the daunting problem of seeing solid growth figures and phenomenal employment numbers, which nonetheless have so far been unable to push soft inflation numbers higher.

Yet experts generally believe that the Fed will stick to its guns, repeating its opinion that low levels of inflation are “transitory”.

The Fed targets 2% inflation and its preferred indicator, the personal consumption expenditure deflator was just 1.4% in July, although the August consumer price index rose to 1.9%, from the prior month’s reading of 1.7%.

A recent Bloomberg survey of economists showed that just 20% felt risks to growth and inflation were to the downside, the lowest amount since March.

Furthermore, 75% of the experts polled said that the Fed wouldn’t change its post-meeting statement to reflect growing concerns over inflation, compared to just 67% in the July survey.

Focus on dot plot

Most analyst previews for the upcoming meeting focused on the possibility that the portion of the Fed’s Summary of Economic Projections that deals with interest rate forecasts, known as the dot plot that assigns anonymous individual estimates for levels over time, would drop slightly.

Morgan Stanley pointed out that the risk to their own call for no change was based on the possibility that just two changes among Fed members could lower the median longer run dot to 2.75% from the prior 3.00%.

They also identified the possibility that the 2018 median dot could drop to 1.875% from the earlier 2.125%.

However, they noted that they believe the “risk is that Yellen takes a more dismissive line toward the downside surprises in the inflation data”, similar to that given in a recent speech by New York Fed president William Dudley.

“Even though inflation is currently somewhat below our longer-run objective, I judge that it is still appropriate to continue to remove monetary policy accommodation gradually,” Dudley said.

“This judgment is supported by the fact that financial conditions have eased, rather than tightened, even as the Fed has raised its short-term interest rate target range by 75 basis points since last December,” he explained.

As it stands, economists in the aforementioned Bloomberg survey generally believed that the Fed would maintain its projection for three hikes in 2018, although the dot plot would show the first to now come in June instead of the prior estimate for March.

ING noted in its own preview that markets currently only price in one rate hike for 2018, far apart from the Fed’s prior projection that there would be three.

“Downgrades to the infamous dot diagram could complicate Yellen\'s efforts to convince markets they are too complacent,” these economists warned.

“While the median 2017 dot is still set to tentatively pencil in a December rate hike, we expect to see more members calling for a pause for the remainder of the year; anything more than five would suggest that hopes of a December hike stand on a fragile footing,” they suggested.

Deutsche Bank does believe that inflation developments will be key and some further evidence of the inflation trend firming is likely needed.

“Some Fed ‘dots’ are likely to fall at the September meeting, but we expect the signal to be that a December hike remains very possible,” these experts said.

“In 2018, we see three rate increases –the first coming in June- in line with the Fed and well above the market,” they concluded.

Dot plot has short shelf life this round

Fed fund futures have kept the possibility of a hike in December in the cards, with odds currently at around 58%, according to’s Fed Rate Monitor Tool.

The focus on Wednesday will likely be on whether Yellen can convince markets to maintain those bets even as the central bank announces its plans to unwind the balance sheet.

As much as the major will also likely be centered on the dot plot for markets to attempt to interpret the outlook for interest rates, pending appointments at the heart of the Fed may render this round a relatively useless tool for a 2018 and 2019 guidance.

With Fed vice chairman Stanley Fischer set to resign mid-October, Yellen’s reappointment in February up in the air (U.S. President Donald Trump recently confirmed that she was a candidate in the running), Fed governor Randal Quarles still awaiting Senate confirmation and two other positions still open for nomination by the President, the dot plot released on Wednesday is wide open to changes.

As current members such as Fischer and possibly even Yellen herself, rotate out of the lineup and new members join the rate-setting team, the composition of the interest rate projections released on Wednesday has the potential to undergo a major shift.

Add to that, further price data that either needs to reinforce or debunk the Fed’s assumption that weak inflation is transitory, the effects on growth of the recent hurricane season and the recovery from it, and the fact that markets will once again face the uncertainty of a debt-ceiling deadline in December.

With all this in mind, all signs point to the fact that the dot plot for the September meeting may indeed have a very short shelf life.

Stay up-to-date on market expectations for Fed rate hikes with's Fed Rate Monitor Tool:

Fed Expected to Hold Rates, Announce Tapering and Offer 'Transitory' Dot Plot

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Comments (1)
Silverbug 19
Silverbug 19 Sep 20, 2017 11:13AM ET
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So $2Tril in MBS @ or around 0%,and $2 Tril in non performing assets that nearly brought down the financial industry.
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