Global Daily – No rush for Fed to shrink balance sheet

by: Maritza Cabezas , Arjen van Dijkhuizen

Fed view: FOMC discusses plans to reduce balance sheet – The minutes of the May FOMC meeting suggest that most Fed policymakers agreed on a general approach to reduce the Fed’s balance sheet in an orderly way as long as the economy and the path of the federal funds rate evolve as expected. The proposed approach for shrinking the balance sheet, as announced in the minutes is predictable and gradual. The proposal suggests setting caps on the dollar amounts of Treasury and agency securities that would be allowed to run off each month and only the amounts of securities repayments that exceeded the limits would be reinvested each month. The caps would initially be set at low levels and raised every three months. As the caps increase, reinvestments would decline and the reduction in the Fed’s securities holdings would become larger.

170524-Global-Daily.pdf (56 KB)

On top of this, Fed officials thought it would “soon be appropriate” to raise short-term rates again. This confirms that Fed officials intend to stick to their plans despite the somewhat weaker data in the first quarter. Most FOMC members saw the slowing down of the economy as temporary, reflecting “transitory soft consumer expenditures and inventory investment”. Importantly PCE growth was expected to pick up to a stronger pace in the spring, which would be consistent with “ongoing gains in employment, real disposable income and households’ net worth”.  We expect a rate hike in June and another in September. (Maritza Cabezas)

China: Downgrade Moody’s – Today, Moody’s downgraded China’s sovereign rating by one notch from Aa3 to A1, changing the rating outlook from Negative to Stable. The main reason for the downgrade is an ongoing rise of overall debt levels, in combination with a slowing of potential growth.  Moody’s is now at par with Fitch (A+, stable outlook) and one notch below S&P (AA-, negative outlook). In our view, the downgrade does not come as a complete surprise, given that Moody’s already put its rating on negative outlook in March 2016 reflecting debt concerns. Moreover, despite Beijing’s intensification of targeted tightening policies aimed at reducing excessive financial leverage and shadow banking and some cooling of overall credit growth, credit growth still outpaces nominal GDP growth by a substantial margin. Hence, already high overall debt levels keep rising (to around 260% of GDP in 2016). The fact that Moody’s has changed its outlook to Stable (stating that upside and downside risks to the A1 rating are broadly balanced) is an important signal, as it shows that the rating agency does not expect that further downgrades are likely on the near-term horizon (Arjen van Dijkhuizen).