Global Daily – How the Fed could spring a dovish surprise this week

by: Bill Diviney

Fed View: New year, new FOMC, new balance sheet policy? – The FOMC is widely expected to keep policy on hold this Wednesday. Given the significant shift in communication from Fed officials in recent weeks, the focus will be on any further tweaks to the statement, and on Chair Powell’s first press conference of 2019. This FOMC will also see a rotation of regional Reserve Bank presidents from the voting chairs, with Bostic (Atlanta), Daly (San Francisco) and Barkin (Richmond) out, and George (Kansas), Rosengren (Boston) and Bullard (St Louis) coming in. On balance, we think the 2019 set of voting members will have a more dovish tilt than that of 2018, particularly against the backdrop of a softening growth outlook. This supports our view that the rate hike cycle has come to an end.

Minimal statement changes, but a dovish outlook…
With that said, we expect minimal changes to the statement at this stage, given that the market has already moved significantly to price almost no tightening for the coming year. While we believe the Fed is done with rate hikes, we think the tightening bias will remain in the statement language (i.e. that the Fed expects ‘some further gradual increases’ in rates), as it did at the end of the last rate hike cycle in 2006-7. However, there could be more explicit reference to the data dependence of further rate hikes, and we expect Chair Powell to sound cautious over the outlook at the press conference given the global slowdown, and domestic risks such as potentially further government shutdowns, and tightening financial conditions. He will likely continue to emphasise the data dependence of the Fed’s moves going forward, and signal that further tightening is not imminent.

…and potentially an update to the balance sheet policy
​In the Q&A, Chair Powell will almost certainly be asked about the Fed’s ongoing balance sheet unwind. In previous press conferences, he has batted away such questions, downplaying the impact of the balance sheet. More recently, however, he and other Fed officials have signalled more openness on the topic, stating that while they see little evidence that it is having a big impact on the markets or the economy, that it is possible they would make adjustments to the policy. Indeed, the Wall Street Journal reported last Friday that Fed is close to a decision on what the ultimate size of the Fed’s balance sheet should be – or, more specifically, the level of excess reserves. The latest NY Fed survey of primary dealers suggests expectations that reserves will stabilise at around USD1trn, which implies a balance sheet of USD3.5trn – around USD800bn lower than current levels. At the current rate of the runoff, that would imply normalisation ending by around Q1 2020. While it is unclear what the market is pricing in for the balance sheet, a move to publicly announce an end-date to the unwind would be a dovish surprise, in our view. (Bill Diviney)