Fed expected to reduce balance sheet

The US Federal Reserve’s FOMC concludes its two-day monetary policy meeting this evening. The FOMC will update its economic projections and give its latest forecasts for GDP growth, unemployment, inflation and interest rates.

The Fed is also expected to reveal details of how and when it will begin to wind down its $4.5 trillion balance sheet. The Fed is aiming to reduce it to around $2-2.5 trillion by allowing $10 - $50 billion of bonds to mature each month without reinvesting the proceeds. The programme is expected to begin next month. So a $2 trillion reduction even at the higher $50 billion per-month rate suggests a wind-down period of around four years. This sounds cautious enough. However, in just the same way that this form of quantitative easing had never been tried before, it follows that no one has ever attempted to reduce it either.

Back in July Janet Yellen indicated that the Fed could be closer to its interest rate target, or neutral policy stance, than the market was then anticipating. This led to a repricing of the Fed’s objective to 1.75/2.00% from around 3.00%. Dr Yellen also emphasised the importance that the FOMC placed on boosting inflation. This is significant as annualised Core PCE (the Fed’s preferred inflation measure) has been trending downwards since the beginning of the year and, at 1.4%, is currently well short of its 2% target. This suggested that the US central bank was considerably more dovish than previously thought. So there’s going to be a stack of information to take in tonight which has the potential to shift markets sharply - particularly if the Fed appears more hawkish than expected. But if it keeps to the path sketched out over the summer, the dollar should continue to weaken and push the EURUSD back above 1.2000. This won’t be good news for the ECB, but ultimately it will help the Fed get inflation up towards target.