The dollar did a big drop today after the FOMC announcement left rates unchanged. The Federal Reserve said the reduction of the balance sheet will begin relatively soon. I think relatively soon means September 2017.

The Fed seemed to indicate that “gradual” policy tightening will continue.

The Federal Reserve will begin winding down the stimulus program it embarked on to save the economy from the financial crisis. As expected, the Fed unanimously declined to raise interest rates.

The Fed predicts inflation will stabilize around the Committee’s 2% objective over the medium term despite inflation being below 2% in the near term. The Fed said they continue to expect “gradual increases in the federal funds rate”.

Fed Announcement Pushed Down the US Dollar

US dollar chart plunged after FOMC announcement on July 26, 2017.

What the drop in the US dollar is telling us is that the Federal Reserve is dragging its feet. Just a few months ago, the Fed suggested we would get a rate increase in September. Instead, the Fed has backed off of that and now is toying with the balance sheet. The Fed seems to be telegraphing that it wants to slow down on tightening if inflation and wages don’t play out the way that they expect. I think the low inflation rate and low wage growth is really bugging the Fed because inflation should not be this low, at this time, in the economic cycle. Without a threat of runaway inflation, I think the Fed now feels that there’s no reason to rush another rate hike. This is all dovish which explains why the US dollar took a big dump today.

The FOMC announcement suggests they will begin quantitative tightening (QT) in September as they begin rolling off the $4.5 trillion portfolio of bonds it has accrued on its balance sheet, largely in the years after the crisis and the Great Recession. Balance sheet reduction is really the new QT as explained here.

The committee expects to begin implementing its balance sheet normalization program relatively soon, provided that the market evolves as expected.

The Fed also offered a bit more information on the balance sheet reduction strategy. Having ballooned to $4.5 trillion thanks to QE, the Federal Reserve has already announced a strategy of gradually limiting the reinvestment of proceeds of maturing assets. The question has been the timing. This statement suggests it will begin “relatively soon”, whereas previously they had merely stated it will start this year. I think traders are pricing in a balance sheet reduction to start either in September or October. Efforts will entail allowing a restricted level of proceeds from the bond portfolio to run off. The program will begin at $10 billion per month and increase to $50 billion. Fed officials estimate that once the program has run its course, the balance sheet will probably still exceed $2 trillion.

Chair Janet Yellen and many others have suggested that the balance sheet runoff should not be disruptive to markets, though it’s possible that QT may push up rates if demand for the bonds the Fed is rolling off are not absorbed by private markets and central banks in other countries. However, we do not see any sign of that happening yet.

Janet Yellen really tried to downplay the planned balance sheet reduction last month.

The other big focus in Wednesday’s FOMC announcement was the Fed’s perspective on inflation. The core personal consumption expenditures index has dropped away from the central bank’s target for the last four months. The softer inflation figures together with the probability of a September balance sheet reduction means that December is likely the next month the Fed will consider hiking rates.

General inflation, excluding energy and food prices, has declined and is running under 2%.

Fed Board Chair Janet Yellen told Congress that temporary variables like prescription drugs and cheaper cellphone programs were behind the inflation downturn.

Markets didn’t expect the Fed to increase rates at this meeting. Dealers from the fed funds futures market are assigning about a 50-50 chance the central bank does one more rate hike before the year’s end.

In assessing the economy, the FOMC announcement showed that the committee held to its assessment that action was rising moderately so far this year. On inflation, the statement removed the word “somewhat” from June’s verbiage and said simply that inflation was running “under two percent,” a subtle tweak which nonetheless probably signifies officials are somewhat more cynical about reaching their mandated objectives.

Average hourly wage growth was stuck around 2.5 percent. Other inflation measures are even lower, with the Fed’s preferred estimate, the personal consumption expenditures index, at 1.4 percent.

Looking further ahead, we are still on with the prediction for two rate increases in 2018, anticipating reasonable 2-2.5% GDP growth over the next year and a likelihood that inflation will slowly return to target, helped by a tight labor market and the possibility of a gradual uptick in wage growth.

If you have any thoughts on the FOMC announcement feel free to comment below.

Here is the full FOMC announcement.

FOMC Announcement

Information received since the Federal Open Market Committee met in June indicates that the labor market has continued to strengthen and that economic activity has been rising moderately so far this year. Job gains have been solid, on average, since the beginning of the year, and the unemployment rate has declined. Household spending and business fixed investment have continued to expand. On a 12-month basis, overall inflation and the measure excluding food and energy prices have declined and are running below 2 percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee continues to expect that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, and labor market conditions will strengthen somewhat further. Inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee’s 2 percent objective over the medium term. Near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely.

In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 1 to 1-1/4 percent. The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.

For the time being, the Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Committee expects to begin implementing its balance sheet normalization program relatively soon, provided that the economy evolves broadly as anticipated; this program is described in the June 2017 Addendum to the Committee’s Policy Normalization Principles and Plans.

Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Patrick Harker; Robert S. Kaplan; Neel Kashkari; and Jerome H. Powell.


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