Fed Maintains Interest Rates, Announces Start To Balance Sheet Normalization

Having already laid the groundwork with two interest rate hikes this year, the Federal Open Market Committee took an unprecedented step to tighten its monetary policy Wednesday.

As expected, the FOMC confirmed it would begin to contract its sizeable balance sheet and shrink its bond portfolio in October.

Although this is generally done through the sale of assets and liabilities, the committee earlier rejected this market-disrupting route and instead committed to a passive strategy of “ceasing or phasing out the Fed’s current practice of replacing or rolling over maturing assets.”

The central bank holds more than $4.5 trillion in assets, largely built during the financial crisis when it began buying long-term Treasurys and mortgage-backed securities.

How This Could Play Out

Some are optimistic that the Fed can effect gradual changes without shocking the system.

“The Fed is continuing what it has done well so far – that is, engineer a slow and orderly normalization of unconventional policies without derailing economic growth or causing unsettling financial volatility,” Mohamed El-Erian, chief economic adviser at Allianz, told Benzinga.

However, others are dubious.

“The Fed is deliberate and calculated about raising interest rates, and the last two rate hike cycles have resulted in recessions,” Greg McBride, Bankrate.com’s senior vice president and chief financial analyst, told Benzinga. “That’s a tool they’re used to working with, and this one is uncharted territory.”

The execution timeline poses a significant risk to the nation’s sensitive economic stability.

According to Bankrate, the delineated plan increases the possibility of long-term interest rate raises, abrupt stock market correction and deceleration of economic growth, the last of which could bring about a recession. Other economists warned of a correlated decrease in asset prices.

“The pace the Fed has laid out would reduce their holdings by $1 trillion by the end of 2019,” McBride said. “We’d be naive if we think that the Fed can downsize their portfolio by $1 trillion in a little more than two years without some bumps.”

El-Erian considers the primary risk to success in international factors, such as activity by other central banks, rather than any internal or domestic disturbances.

Interest Rates Untouched

The FOMC maintained interest rates between 1 percent and 1.25 percent. It resolved to pursue another increase in December and projected three additional hikes in 2018, two in 2019 and one in 2020.

The committee further sees the funds rate at:

• 1.4 percent by the end of 2017;
• 2.1 percent by the end of 2018;
• 2.7 percent by the end of 2019;
• And 2.9 percent by the end of 2020.

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Image Credit: Federal Reserve Chair Janet Yellen speaks during an appearance at the University of Michigan on Monday. "Our independence is under some threat," Yellen says of the Fed. Photos by Dustin Blitchok.