Time to Talk about the End of Reinvestment

The minutes reinforced our FOMC call: We expect two more rate hikes this year—in June and September— and a change in reinvestment policy by the end of this year. We have also said that a change in reinvestment policy before the end of this year would likely substitute for a December rate hike if the FOMC would otherwise have been inclined to hike four times. And that remains our view. 

FOMC participants explained why they hiked in March. And they stressed that this hike was fully consistent with their guidance that the path of rate hikes would be gradual. 

▪ There was no change in the view of the outlook since the January meeting. As they indicated at that time, further rate hikes would be forthcoming should the economy evolve as expected. It has. ▪ The minutes also communicated the Committee’s view that it is now (really) on a course of gradual rate  hikes, what we called “a return to gradualism.” 

Participants reaffirmed the approach to balance sheet normalization that was announced in September 2014. ▪ Participants agreed that changes in balance sheet policy should be “gradual and predictable, and accomplished primarily by phasing out reinvestments of principal received from those holdings;” that is,  by tapering the end of reinvestments. 

▪ It was agreed that the Committee’s intentions about reinvestment policy should be communicated “well  in advance.”  

▪ “Several” participants said that when it becomes time to announce changes to the reinvestment policy,  “it would be desirable to also provide more information to the public about the Committee’s expectations  for the size and composition of the Federal Reserve’s assets and liabilities in the longer run.” Clearly, this is an issue that remains under active discussion. 

There was also additional information revealed in the discussion about balance sheet normalization. ▪ Nearly all participants said that they preferred the timing of the change in reinvestment policy to depend on an assessment of economic and financial conditions, though “several” participants argued that there should be a quantitative rather than qualitative threshold tied to the federal funds rate. ▪ Most participants believed that it would be appropriate to change the reinvestment policy before the end of the year, conditional on the data coming inconsistently with their forecasts.  

▪ When the reinvestment policy is changed, participants generally preferred to phase out or cease reinvestment for both Treasury securities and MBS. We note this because there is a case for not ending reinvestment for Treasuries at any point if the target size of a normalized balance sheet is large, and especially if the desired composition is all Treasuries. 

▪ Participants discussed the costs and benefits of phasing reinvestment for both Treasuries and MBS out or ceasing reinvestment all at once. 

▪ The minutes did not mention the argument, a view that we share with Dudley, that the announcement of a change in reinvestment policy would result in tighter financial conditions and therefore result in the  FOMC delaying a rate hike that would have otherwise happened. 

While there was wide agreement that the economy is at or close to full employment and that the economy is growing at or above potential, there continued to be differences with respect to views on inflation and the implications for the course of monetary policy. 

▪ Some participants argued that the progress back to 2% should not be overstated. Inflation had been running below 2% throughout the expansion and 12-month core inflation remained below 2% and had changed little in recent months. (The FOMC did not have February data.)  

▪ On the other hand, several others said the Committee had essentially met its 2% inflation goal or was poised to do so later this year. In their view, such circumstances could favor a faster pace of rate hikes than implied by the median assessment of participants in the SEP. 

▪ As for the voting members of the FOMC, “nearly all” judged that the 2% objective for headline inflation had not yet been achieved on a sustained basis. So they are not there yet. 

▪ “A few” members cautioned that the Committee’s actions and communications should avoid suggesting  that the 2% inflation objective was a “ceiling.” 

▪ Several also said that it would be useful to have an explicit recognition in the statement that the inflation objective is symmetric; indeed, the phrase “relative to its symmetric inflation goal” was added in the  March statement. President Evans seems to have some company! We expect to see this theme gain traction in advance of a likely (modest) overshoot of the 2% objective! 

Participants thought the risks to the outlook were “roughly balanced.” 

▪ About half included an assumption of fiscal stimulus in their projections. But “several” in that group moved the timing of this stimulus later, to 2018. The staff also delayed its assumed fiscal stimulus. By doing so,  they are moving closer to our view on fiscal policy. 

▪ However, “most” participants continued to see fiscal policy as a source of upside risk to their forecast,  though “some” saw downside risk from possible changes to other government policies, for example regarding trade and immigration. 

▪ Participants saw improved household and business sentiment as sources of upside risk. Financial  conditions were seen as providing risks to both the upside and downside: They “posed upside risks to  their economic projections, to the extent that financial developments provided greater stimulus to  spending than currently anticipated, as well as downside risks to their economic projections if, for  example, financial markets were to experience a significant correction.” 

▪ There was a lengthy discussion of asset valuation, centered on equity prices. A “few” participants attributed the rise in equity prices since the election to improved risk appetite or the expectation of a  corporate tax cut rather than to expectations of stronger economic growth. “Some” thought equity prices were high relative to standard valuation measures. ▪ We saw this paragraph as the FOMC signaling its awareness of some vulnerability of the economic outlook to a potential reversal of the recent gains in the stock market, especially if there were any material reassessment of the prospects for these policies.

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