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Fixed-Income Insights

U.S. policymakers delivered another rate increase on June 14, but also signaled the beginning of efforts to reduce the size of the central bank’s balance sheet. 

As telegraphed by U.S. Federal Reserve (Fed) policymakers—and as expected by investors—the Federal Open Market Committee (FOMC) raised its benchmark fed funds rate by 25 basis points (bps), to a range of 1.00–1.25%, on June 14. (The FOMC is the Fed’s policy-setting arm.) However, this change in the Fed’s basic monetary policy instrument was of far less importance to investors than two other agenda items. 

Of more immediate concern to investors were the FOMC projections for the economy, inflation, and fed funds. Longer term, discussions of potential changes in the Fed’s portfolio captured investor interest. Both of these factors help shape investors’ expectations for interest-rate movements, particularly over the next 18 months. 

Fed funds futures suggested that investors were prepared for some downward adjustment to various FOMC projections, especially after inflation news so far this year that has been lower than expected and fiscal initiatives that have failed to materialize. Instead, the Fed largely held fast to earlier forecasts. Gross domestic product (GDP) projections for 2018 and 2019 remained unchanged, at 2.1% and 1.9%, respectively. Inflation projections (as measured by the Personal Consumption Expenditures [PCE] Index) also were unchanged for 2018 and 2019, at 2.0% each year. As important, for the short term, projections for 2017 GDP were revised slightly higher, to 2.2%, from 2.1% in March. The projection for PCE inflation for 2017 was revised noticeably lower, to 1.6%, from the 1.9% level in March. 

Despite a lower projection for inflation, the Fed’s latest “dot plot” projection continues to reflect one more rate hike in 2017 (see Chart 1). As before, three additional rate hikes continue to be projected for 2018. 

 

Chart 1. Connecting the Dots on the Direction of Fed Policy
Federal Open Market Committee assessment of appropriate fed funds rate, 2017–onward (as of June 14, 2017)

Source: U.S. Federal Reserve. The “dot plot” is a statistical chart consisting of data points plotted on a simple scale. Each shaded circle indicates the value (rounded to the nearest 1/8 percentage point) of an individual Federal Open Market Committee member’s view, where each participant at that particular meeting thinks the fed funds rate should be at the end of the year for the current year, the next few years, and the longer run. 
Forecasts and projections are based on current market conditions and are subject to change without notice.
Projections should not be considered a guarantee.

 

Investors were rather sanguine about the Fed’s projections. The fact that just prior to the announcement, fed fund futures implied less than a 37% chance of a third hike this year, and at most only one hike in 2018, suggested that yields might move higher with the Fed’s expectations. Instead, the yield on the 10-year U.S. Treasury note was 2.11% after the release of the Fed’s projections, according to Bloomberg, unchanged from before the announcement. U.S. equity markets improved only slightly after the Fed release. 

With regard to potential changes in the Fed’s portfolio, the press release offered surprising clarity. Reduction of the central bank’s portfolio holdings will begin later this year, at a pace of $10 billion per month. Principle payments to the Fed will be reinvested only to the extent they exceed rising caps. The initial cap for Treasury principal payments will be $6 billion per month, and for agency debt and mortgage-backed securities, $4 billion per month. Caps will rise every three months, at $6 billion and $4 billion for Treasury and agency portfolios, respectively, until they reach $30 billion and $20 billion per month, respectively.

The gradual pace and split between Treasury and agency securities created little concern among investors, and essentially generated no price impact among securities. For a meeting that involved a rate change, fresh projections for economic growth, inflation and Fed funds as well as detail on reduction of the Fed’s portfolio, there was surprisingly little impact. And that is probably just fine with the Fed. 

 

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