Fed Keeps Rates Steady; Hints Balance Sheet Selloff Is 'Soon'

(Post Fed Announcement) There’s not much to see here folks. The Federal Reserve appears to have become a master of telegraphing its message to the markets and investors well ahead of announcing its interest-rate “decision” and showcased that again today when it said that it would keep the Federal funds rates in a range of 1% to 1.25%.

What did change in its statement is that it “expects to begin implementing its balance sheet normalization program relatively soon,” addressing the well-anticipated nod to its plan to begin unraveling the $4.5 trillion package of Treasury and mortgage-backed securities that were used to prop the economy during the depths of the recession. Some analysts were hoping to hear exactly when that might be, but the statement only hinted to “soon.” That does not wipe out a September start, as many analysts have expected, but doesn’t guarantee one either.

“In view of realized and expected labor market conditions and inflation, the committee decided to maintain the target range for the federal funds rate,” the statement reads, reiterating last month’s statement.

Is Fed Submitting to Low Inflation?

Inflation, which has stubbornly stayed below 2%, appears to still be an issue to the Fed, which tightened its wording in today’s statement in what might be an acquiescence to the lower measure. The statement changed the phrasing to note that “Inflation on a 12-month basis is expected to remain somewhat below 2% in the near term but to stabilize around the committee’s 2% objective over the medium term,” rather than the previous “is running somewhat” below 2%.

As usual, the statement noted that “The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2%.”

Also like previous statements, there was no tangible missive attached detailing when the next interest-rate increase might take place, but Chair Janet Yellen’s testimony to Congress earlier this month might have been more telling. In it, she seemed to switch her hawkish outlook to a more dovish one by acknowledging that the Fed might be stuck between a rock and a hard place. (See below)

“Of course, considerable uncertainty always attends the economic outlook,” she repeated as a cautionary measure. “There is, for example, uncertainty about when—and how much—inflation will respond to tightening resource utilization.” In other words, it appears the Fed has no idea if pushing interest rates higher will tweak inflation.

Ahead of the announcement, the CME’s FedWatch tool held fast to its mere 3% probability that a rate increase was in works. A step up in rates to a range of 1.25% to 1.50% by December also still sits at about a 47% probability. The likelihood of increases before that when the Fed meets in September and November lost some momentum after the announcement, dwindling from high and mid to low single digits in both cases.

The Fed had said it hoped to raise rates four more times by the end of 2018, but that mission might get derailed as the economy continues to grow at a snail’s pace and inflation stays below that targeted 2% level.

The FOMC will meet again for two days beginning Sept. 19—before which the Fed will have seen a boatload of economic reports and even more earnings. The decision on interest rates is scheduled to be made during the Sept. 20 meeting, which also has a press conference on the dockets. Yellen typically does not seem to like to raise rates without a press conference to talk them through, but as noted above, the fed funds futures isn’t pricing in much likelihood of a rate increase by September.

And the Markets…

They stayed chugging on the same record-setting pace they’ve been enjoying all week, juiced by fundamentals that earnings season is providing. The advances in the S&P 500 (SPX) and Nasdaq Composite (COMP) upward weren’t massive by any definition and didn’t pick up much steam after the decision, but stayed in record territory. The Dow Jones Industrials ($DJI) was tracking higher by 70-plus points ahead of the announcement and jumped over 100 points quickly afterward.

Meanwhile, there doesn’t appear to be much worry in the markets, judging by the Volatility Index (VIX). The market’s so-called fear gauge has been consistently dipping to historic lows, scraping at 8.84 earlier today, its lowest reading in history. It was on pace to log a close above 9.

FIGURE 1: LOOK MA, NO HANDS! The Volatility Index (VIX), plotted here Wednesday on the TD Ameritrade thinkorswim® platform, appears to be reflecting the calm among the  markets and the economy overall, as it dipped to record lows ahead of the Federal Reserve’s decision to keep interest rates steady. Data source: CBOE. For illustrative purposes only. Past performance does not guarantee future results.

Putting the Cart before the Horse

As noted above, the Fed plans to begin unraveling the $4.5 trillion balance sheet “soon,” and maybe as soon as September, if some analysts expectations ring true. Does it plan to alternate between interest-rate hikes and balance sheet selloffs? In speeches she made earlier this month, Fed Gov. Lael Brainard might have implied something along those lines:

“…It is worth noting that the two tools for removing accommodation—raising policy rates and reducing central bank balance sheets—appear to affect domestic output and inflation in a qualitatively similar way,” she said. “This means that central banks can substitute between raising the policy rate and shrinking the balance sheet to remove accommodation, just as both were used to support the recovery following the Great Recession.”

Today’s statement did not make mention of pursuing alternative normalization strategies.

A Job Well Done…and Done?

Chair Janet Yellen’s term, which expires in January, might be extended, according to an interview President Trump had with the Wall Street Journal that was reported today. “She is in the running, absolutely,” he said. “I like her; I like her demeanor. I think she’s done a good job.”

He added: “I’d like to see rates stay low. She’s historically been a low-interest-rate person.” He also noted there were “two or three” other contenders.

Identifying the Hawks and Doves

Is the Fed moving toward a dovish tone? (See story.) Today’s unanimous vote might be telling, but remember the votes don’t always pinpoint exactly which members are for or against raising rates because some will vote with the majority to send a unified message.