US: FOMC appears ready to start reducing the balance sheet - Nomura

Analysts at Nomura think that the FOMC appears ready to start reducing the balance sheet and future rate hikes will depend on the evolution of labor markets and inflation.

Key Quotes

“Economic activity: The US economy continues to grow above potential, a trend we expect to continue. Domestic demand is the primary factor driving growth. Consumer spending has been growing modestly and investment has picked up in 2017 relative to last year. Job growth averaged 194k in Q2, well above the sustainable pace. Indeed, the unemployment rate has fallen to levels not seen since 2001 (Low Unemployment: Not as Low as it Seems, 16 June 2017). We expect low productivity growth to be a persistent constraint. In the first half of 2017, productivity growth is likely to be well below 1%.

Another reason for the steady expansion has been a lack of adverse shocks. Looking ahead, expectations for positive stimulus from fiscal policy have diminished. We now expect the Republican Congress and President Trump to be able to pass modest tax cuts in late 2017. Further, we expect only small increases in government spending.”

“Inflation: We expect lower inflation in the near term. Oil prices trended lower in Q2 and transitory factors such as wireless telecom services weighed on inflation. Yet, over the medium term we expect inflation to pick up as labor markets tighten. Against this backdrop, we think core inflation will grow slightly faster in 2018 and 2019. Core PCE inflation may trend gradually higher as core goods and healthcare service inflation picks up while rent inflation slows.”

“Policy: We expect the FOMC to continue on its gradual removal of accommodation by raising short-term interest rates again in December. In the interim, we expect the FOMC to announce the decision to begin the process of shrinking its balance sheet at its September meeting. We continue to expect two more hikes in 2018 to the terminal rate of 2%. We forecast that the FOMC will stay at this level and will not hike further in 2019.”

“Risks: Financial conditions pose several risks to the forecast. Currently, financial conditions have eased considerably so far this year despite three Fed hikes. However, financial conditions could turn quickly in response to the Fed’s balance sheet policy or to some unanticipated event. Although we believe this risk to be modest, it deserves attention. External risks are also noteworthy, especially as the Trump administration may pursue more aggressive trade policies that could result in retaliatory actions by US trading partners. Again, we believe this risk to be small at the moment, but still relevant.”