Still on course: Fed signals one more rate hike in 2017

Posted by jbrumley on September 20, 2017 5:11 PM

- FOMC takes first step to reverse massive bond-buying spree -

By Jeffry Bartash, MarketWatch

The Federal Reserve still plans to raise interest rates once more before year end, but the central bank on Wednesday signaled its cycle of rate hikes might end sooner than planned.

In a long-anticipated move, the Fed also announced it will slowly shrink its huge $4.5 trillion balance sheet starting in October. Read text of FOMC decision.

The central bank took an unprecedented step beginning in 2008 to buy trillions of dollars of bonds in a frantic effort to lower U.S. interest rates and help a feeble economy recover from the Great Recession. Nearly nine years later Fed officials believe the economy is strong enough to stand more on its own.

“The basic message here is U.S. economic performance has been good,” Chairwoman Janet Yellen said in a press conference after Fed officials concluded a two-day meeting.

The confidence was reflected in the Fed’s willingness to stick to its current timetable for raising interest rates despite a surprising slowdown in inflation. A so-called dot plot summarizing the views of senior officials show they soon expect to lift a key short-term rate by one-quarter point to a range of 1.25% to 1.5%.

Most analysts believe the Fed will wait until December. The most notable market move was a rise in the 10-year Treasury yield TMUBMUSD10Y, +0.98% while U.S. stocks SPX, +0.06%  closed at record highs.

Although the Fed has not dramatically reassess its current strategy, the central bank did scale back its estimates of how high interest rates will rise. The Fed remains on track to raise its benchmark fed funds rate three times in 2018, but it only pegged two further rates in 2019 instead of three. The bank also lowered its long-run target to 2.8%, the first time it’s fallen below 3%.

Fed officials have been puzzled by the persistence of low inflation even as the unemployment rate fell in July to a 16-year low of 4.3%. Yet wages still aren’t rising as rapidly as conventional economic wisdom would suggest, a trend also evident in other major economies.

Several times Yellen referred to doggedly low inflation as a “mystery,” but the Fed stuck to its tried-and-true forecast that it will eventually rise to 2%. The bank’s preferred 12-month measure of inflation stood at just 1.4% in July.

The Fed also repeated its view that unemployment is likely to end at 4.3% in 2017, fall slightly to 4.1% in the next year and then hold steady.

The Fed’s forecasts imply the bank is unwilling to freeze interest rates in an experiment to see how low unemployment can go without stoking inflation. Some bank officials want to pursue a less aggressive approach until clear evidence of rising inflation emerges, but that’s not a majority view.

“It is too soon for the committee to conclude that the recent slowing in inflation was sufficiently permanent to alter the Fed’s plans,” economists at Barclays wrote in a note to clients.

The Fed also has to contend with a murkier view of the U.S. economy in the aftermath of hurricanes Irma and Harvey. Yellen said the disruptions could hurt the economy in the third quarter, boost growth in the fourth quarter and raise inflation temporarily owing to higher gas prices.

The path of U.S. growth, however, is unlikely to change. The bank projects roughly 2% economic growth over the next few years, keeping in line with Fed forecasts stretching back several years.

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The central bank said it would start in October by letting $10 billion in bonds mature each month, slowing ratcheting up that number until it reaches $50 billion.

What’s unclear is how long the process will go on and where the Fed will end up. The central bank held more than $800 billion in assets when a financial crisis struck in 2008, but the Fed is expected to keep a portfolio three to four times larger once the process is complete.

There’s much at stake.

If the asset runoff leaves financial markets largely undisturbed, the Fed would have gained credibility for a new tool to fight major recessions in the future. Yet if the process goes awry — stocks tumble, mortgage rates soar, the economy falters — the controversial central bank strategy could be discredited.

Another big question mark: Who will be running the Fed in 2018 and beyond?

Yellen’s tenure as chairwoman expires in February, and President Trump is still considering whether to retain or replace her. The White House also has to fill four other positions on the Fed’s rate-setting board, giving the president the power to dramatically reshape the central bank’s leadership.

Yellen declined to comment on the likelihood of her getting a second term and said she hasn’t met the president in some time.

From MarketWatch

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