Fed View: Surprise pivot to a neutral policy outlook – The FOMC unexpectedly removed the tightening bias from its policy statement yesterday, supporting our view that the rate hike cycle is over. While we felt some further dovish tweaks to the statement were possible, the removal of the reference to ‘further gradual increases’ in rates was a surprise at this early stage, as was the switch to neutral language surrounding ‘future adjustments’ in rates – suggesting the next move could be up or down. This paves the way for a further fall in the FOMC dot plot interest rate projections when they are updated in late March. In the press conference, Chair Powell sounded a dovish tone, contrasting a sanguine view of the broad macro picture in the US with a further reference to ‘cross-currents’ that pose risks to the outlook. These range from weakening growth in China and Europe, to the government shutdown (and the potential for further shutdowns), and uncertainty related to Brexit and the US-China trade negotiations.
Likely an earlier end to the balance sheet run-off…
The FOMC also provided further guidance on its ongoing discussions on the balance sheet. As we had flagged in our preview, the Fed is considering providing clearer guidance on where it sees the ultimate size of the balance sheet, signalling that the balance sheet run-off will end sooner than some market participants may fear. While we did not get anything precise today, the statement on the balance sheet made explicitly clear that the Fed would not revert to a regime of using reserve balances to control interest rates, which would have implied a substantially smaller balance sheet than at present, but that it intended to have a regime with ‘an ample supply of reserves’. In his press conference, Chair Powell went further, stating that the balance sheet size will be determined principally by ‘financial institutions’ demand for reserves, plus a buffer’. While the Fed is still discussing how to determine that precise level, Powell gave a hint by referring to ‘surveys’ (likely the NY Fed’s primary dealer survey), which suggests ‘normalisation (…) will be completed sooner, and with a larger balance sheet, than previous estimates’. The Fed would ‘finalise these plans at coming meetings’. We believe the Fed will likely project an end to balance sheet normalisation by the first half of 2020.
…but a high bar to use it as a policy tool?
While the Fed is signalling a somewhat quicker end to the balance sheet normalisation, it emphasised its resolve to use the fed funds rate as the primary means to provide policy accommodation in any future downturn. The updated guidance states that ‘the Committee would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate.’ In other words, rates would likely have to hit the zero lower bound before the Fed uses the balance sheet to ease policy, be that through the composition or through net asset purchases. (Bill Diviney)