Fed outlines QT principles and expects to hike ‘soon’ – Danske Bank

Senior Analyst, Mikael Olai Milhøj at Danske Bank, notes that on the rate hike outlook in the recelnly ublished FOMC Minutes, ‘most participants’ (both covering voting and non-voting FOMC members) think a rate hike will be appropriate ‘soon’.

Key Quotes

“As mentioned in the statement, the FOMC members were not worried about the weak GDP growth in Q1, which they think is transitory and partly reflecting negative residual seasonality. The members also noted that the unemployment rate had dropped further below the Fed’s NAIRU estimate of 4.7%. That said, ‘a few participants’ think it is a ‘concern’ that the progress on the inflation goal has slowed (and remember the meeting took place before the CPI data for April).”

“Overall, the Fed admits it is in a difficult position. On the one hand the Fed should likely hike rates as it has met its employment objective; on the other, the Fed should be more cautious as it has missed its inflation target for eight years (except for a few months). Since the meeting, the problem has only worsened for the Fed. The jobs report for April showed the unemployment rate dipped to 4.4% (the lowest in a decade) while the CPI data for April surprised on the downside, as CPI core inflation dipped to 1.9% .”

“While consensus is that the Fed will hike at the June meeting, we are still more sceptical, because of both the weaker economic data and still too low inflation. However, we just think the Fed will wait until July, so it is not a given it should lead to a major reaction in the financial markets. Thus, it will not be a major surprise for us if the Fed decides to hike in June anyway, also given the current market pricing.”

“Next year we now expect the Fed to hike three times (previously 3-4 times) due to a combination of the Fed’s desire to shrink its balance sheet soon and Trump’s inability to deliver on Trumponomics.” 

“Looking at the market pricing, we still think it is too the soft side. While the June hike is priced in by 80%, the markets have priced one and half hikes for the rest of the year and a total of 2.7 hikes from now until year-end 2018.”

“Fed outlines quantitative tightening principles

• Before the release, we said we would look for any comments on the Fed’s desire to reduce the size of its balance sheet (quantitative tightening) and we were not left disappointed. ‘Nearly all’ FOMC members think it would be appropriate to begin quantitative tightening later this year (most have indicated in speech end-2017 is most likely).
• The minutes state that quantitative tightening will be conducted ‘in a gradual and predictable manner’. The staff proposes that the FOMC announces a set of gradually increasing caps/limits on the dollar amounts of bonds that will be allowed to run off each month and only reinvest the amounts that exceeded the caps each month.
• The minutes also say that the FOMC members agreed to amend Committee's Policy Normalization Principles and Plans “soon”.
• We think this supports our view that the Fed will come with the big announcement of the triggers for starting quantitative tightening in connection with the June meeting.
• We expect the Fed to begin very gradually by a smaller amount than what the Fed bought per month under the QE1 programme (USD30bn per month) but with the idea of increasing caps the amount may rise above this threshold during the reduction phase. In an optimistic scenario the Fed can reduce its balance sheet by USD1,700bn, in our view.”