October flashlight for the FOMC blackout period – Data vacuum clouds the outlook

Summary

We expect the FOMC to announce another 25 bps rate cut at the conclusion of its meeting on October 29. The government shutdown has clouded the U.S. economic outlook as most government data releases are currently delayed. The limited data that have been released suggest that gradual labor market softening has continued alongside inflation that is running at roughly a 3% underlying pace.

We believe the shutdown is having a small but negative impact on the U.S. economy. The rule-of-thumb that each week of the shutdown shaves off 0.1-0.2 percentage points of quarterly economic growth still strikes us as reasonable. Most—though not all—of this output should be recouped in Q1, assuming that the shutdown has ended by then. If the shutdown drags on much longer, key economic data covering the month of October may be outright skipped rather than merely delayed, making it harder for policymakers to assess the state of the economy in real-time.

Against this backdrop, several key FOMC officials have signaled support for another rate cut in October. However, public comments from FOMC officials generally have been careful to acknowledge that rate cuts past October are not guaranteed.

We do not expect any major changes to the language in the post-meeting policy statement and expect Chair Powell's press conference remarks to echo the sentiment from his public remarks on October 14: inching toward neutral, but cognizant of the two-sided risks to the outlook given the current tension between their employment and inflation goals. There will not be an update to the Summary of Economic Projections at this meeting.

Changes to the Fed's balance sheet runoff program also appear to be coming soon. Chair Powell suggested that runoff may end in the "coming months" in a recent speech. A wide range of indicators suggest this would be a prudent move, in our view. There has been a firming in repo rates recently in a sign that bank reserves are closer to ample than abundant. Furthermore, key thresholds have been reached or are close to being hit for the reserves-to-GDP rand reserves-to-bank assets ratios.

Our longstanding forecast has been that the FOMC would announce the end of QT at its meeting on December 9-10, with balance sheet shrinkage ceasing after December 31. We are sticking with that forecast as a base case, although we acknowledge that it is a close call and the Committee may opt to end QT at the October meeting.

If QT runs through year-end, the Fed's balance sheet will have declined by just shy of $2.5 trillion from its peak in the spring of 2022. We estimate the reduction in the central bank's security holdings has exerted 25-50 bps of upward pressure on long-term interest rates.

Note that even if aggregate balance sheet runoff ceases, that does not mean that balance sheet policy has shifted to neutral. If the Fed's balance sheet is held flat for a couple quarters, then it will still be shrinking as a share of GDP. Furthermore, the composition of the balance sheet can continue to evolve such that policy accommodation is still being removed. We look for MBS runoff to continue indefinitely, with these securities replaced one-for-one with Treasury bills. If realized, this would gradually reduce support to the mortgage market from the Fed's balance sheet and put some very modest upward pressure on longer-term yields, all else equal.

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