We project that the FOMC will hike rates two additional times this year–for a total of three hikes–and will begin to phase out reinvestment before the end of this year. But the sequencing of rate hikes and of announcing and implementing the end of reinvestment remains an open question. Here are three plausible options, assuming that these decisions will be made only at meetings with a pre-scheduled press conference.
• The FOMC hikes for the third time in September and also announces in September the start of the phasing out of reinvestment at a specific time before the end of the year.
• The FOMC announces in September the timing of the beginning of the phasing out reinvestment, then hikes for the third time in December.
• The FOMC hikes for a third time in September and announces in December that the phasing out of reinvestment will begin in January 2018.
We see the first option as most likely: The FOMC both hikes for the third time in September and also announces at that meeting that it will begin to phase out reinvestment beginning in October. We see this option as the one most consistent with the guidance from the statement, the minutes, and comments from participants.
• The May minutes reported that there was a consensus that if the economy and the path of rates evolve as currently expected, it will likely be appropriate to begin to phase out reinvestment “this year.”
• In March, participants’ median dot for 2017 year-end indicates it would be appropriate to raise rates three times in total.
• If they raise rates in September, as we expect, then all the preconditions for an announcement about the balance sheet plans will also be in place.
• Announcing the phase-out of reinvestment in December would be inconsistent with the guidance that the actual implementation of phasing out reinvestment will likely begin this year.
There is also guidance that the normalization of the balance sheet will begin once the normalization of the fund’s rate is “well underway”. We read the consensus to be around a likely threshold of 1¼% to 1½% for the fund’s rate. This, too, would point to a September announcement on reinvestment. • Many FOMC participants have said later this year would be a good time to begin to phase out the
reinvestment policy, with a couple of those tying that decision explicitly to the projected level of the funds’ rate at that point: Between 1 and 1½%. If the FOMC hikes in both June and September, then the fund’s rate will be 1¼% to 1½% by year-end. Contingent on economic conditions, we see that as meeting the fund’s rate prerequisite announcing a change in reinvestment policy.
Raising rates and announcing the end of reinvestment at the same time could threaten an adverse market response.
• This risk makes the FOMC’s communication before that meeting even more important than usual. • We are learning more and more about the balance sheet normalization inclinations, both from individual policymakers and the FOMC. The June press conference, the minutes from the June (and July) meetings, and Yellen’s semi-annual monetary policy testimony will likely reveal additional details. The May FOMC minutes already provided a detailed proposal on how balance sheet reduction will be implemented and communicated (click here for our analysis).
• Balance sheet runoff will be tapered and smoothed, which will make it very easy for the market to absorb.
How will Yellen’s upcoming departure from the Fed affect the timing of the end of reinvestment? • An announcement in September, rather than in December, would also provide more room between the reinvestment decision and Yellen’s estimated departure (in February).
• This encourages policy continuity and does not leave the decision about reinvestment as perhaps the first decision for the new chair.
• Doing both the rate hike and the balance sheet announcement in September will also likely give the Committee six months of respite from policy action and allow the new chair to build a consensus for the next rate hike.
• In addition, hiking in September gives the Committee the flexibility to hike the rate four times, should circumstances warrant.
However, some important political risks could affect the decisions of either or both a rate hike or reinvestment announcement in September: An elevated risk of a government shutdown at the end of the fiscal year and the drama associated with approaching the debt ceiling with the accompanying risk of default on the government debt.
• Market volatility might be very high in September and financial risks could be elevated, giving the FOMC pause about taking any action.
• Beginning to push government debt back into the market at a time of looming default might be seen as inadvisable.
• It is too early to make this the baseline case, but if such threats were to loom large, the timetable for further monetary policy actions could be pushed back for a time.
• If September is too early but December would be too late, then the FOMC does have the option of announcing a rate hike or balance sheet reduction at the November meeting, with an (unscheduled) press conference.