FOMC in 2017: Gradual Rise in the Funds Rate; Change in Reinvestment Policy

We continue to expect two more rate hikes this year, the next coming in June. We expect the Committee to carry out a policy with a steadier hand this year, meaning it will be more reluctant to deviate from its course because of developments that do not change its assessment of the underlying fundamentals. ▪ Our theme in 2017 is “back to the plan” of gradual rate hikes, the plan which was apparent in December  

2015 dots. The first test of this “steadier” policy may be the decision at the June FOMC meeting, given the data surprises over the period since the March meeting. 

▪ The Committee will have no trouble looking through the weak Q1 GDP, a repeat of the recent pattern to which it has become accustomed.  

▪ It is even easier to look through the disappointing March reading on payroll employment [link]. Indeed, we see the two-tenth decline in the unemployment rate as more enduring and significant than the smaller gain in payroll employment. 

▪ The unexpectedly soft March CPI report, on the other hand, is more difficult to look through. It may undermine the unity and strength of the consensus at the March FOMC meeting for three hikes, but we do not expect this will stand in the way of a June hike.  

The Committee is focused on moving toward the neutral fund’s rate; however, that may be a moving target. ▪ The estimate that the current real equilibrium funds rate is near zero means that the nominal neutral rate today is near 2%. Moving to a 2% funds rate is therefore the first step on the journey toward rate normalization. We expect the Committee to reach this threshold by the end of 2018. 

▪ But participants appear to believe that the prevailing real neutral funds rate will converge toward its longer run value, estimated by the Committee to be 1% (or a 3% nominal funds rate), over the next couple of years.  Participants project that the funds rate will reach its longer-run level by the end of 2019.  

The Committee is moving closer to changing its reinvestment policy and to making decisions about its long-run operating regime, what a normalized balance sheet will look like, and how to get there. ▪ There appears to be a consensus for changing the reinvestment policy before the end of this year, and that is what we expect. 

 ▪ The Committee is also working toward a consensus on what a normalized balance sheet will look like,

specifically its size and composition [link]. 

Participants are just beginning to talk about the implications of balance sheet normalization for the pace of rate hikes. We call this the ”substitution question.” For how many 25-basis-point rate hikes will balance sheet developments, including the change in reinvestment policy, substitute? 

▪ The normalization of term premiums—the reversal of the declines that resulted from asset purchase and  

maturity transformation programs—has already been underway for some time [link]. This will continue as reinvestment is phased out. 

▪ Our tentative view is that balance sheet development this year, even before the end of reinvestment, might be the equivalent of one 25-basis-point hike in the fund’s rate.  

▪ In this case, the three hikes projected by the median dot this year might be the equivalent of four hikes in terms of how much monetary accommodation is withdrawn this year. 

With More Confidence in the Outlook, FOMC Gets Back to the Plan 

With its decision to hike in March, the FOMC signaled that it is intent on gradually raising rates and is less likely than in 2016 to delay raising rates because of developments such as adverse economic data or financial market volatility. The March dots reveal a very solid consensus for at least two more hikes in 2017. 

The Rates Outlook 

Following our last forecast, in early March, the ten-year Treasury yield declined substantially, likely in part reflecting some softer incoming economic data and diminished expectations for growth. It remains well above its pre-election levels, however. We’ve marked down our forecast for the ten-year Treasury yield somewhat. This reflects both a lower jumpoff and a lower estimate for the steady-state term premium. 

The effects of the Fed’s various balance sheet programs on term premiums are already diminishing. Chair Yellen has cited estimates that suggest the effect on the ten-year term premium might diminish by 15 basis points this year. This form of tightening is the equivalent of perhaps one 25-basis-point fund’s rate hike.

Major Economic Indicators 

By default, values represent seasonally-adjusted, annualized growth rates (%) for the series indicated n the leftmost column. 

Note on Units and Transformations 

“Quarterly” values are q/q rates; “Annual” values are q4/q4 rates. For series followed by units I n parentheses, “Quarterly” values are quarterly averages, and “Annual” values are q4 averages. 

* “Quarterly” values are not compounded to annual rates.

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