Our expectation about the timing of the end of the current reinvestment policy reflects our interpretation of the guidance the Committee and Chair Yellen have provided. First, the FOMC statement says that the timing is linked to when rate normalization is “well underway.” The second element of guidance, as set out by the Chair, is that the timing of the end of the current reinvestment policy will also depend on the “momentum” in the economy. Given our expectations for the outlook and for the number of hikes this year, we expect the current reinvestment policy will end by December this year or, at the latest, early next year.
The Guidance in the Statement: “Well Under Way”
The guidance in the FOMC statement continues to be (bolding is our emphasis):
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well underway.
So what is meant by “well underway”? One interpretation is that it refers to how close the funds rate is to the level that will prevail when normalization is complete—in other words, how close the funds rate is to its neutral level. Another interpretation could be a level of the fund’s rate that is a more comfortable distance from the effective lower bound. Under this interpretation, the FOMC would be looking to establish a big enough cushion so that it could respond to an adverse shock simply by lowering the fund’s rate. That might include, but not be limited to, the need to lower rates if the change in reinvestment policy has a much larger restraining effect on the economy than expected.
Under the first interpretation, there is additional ambiguity. If “well underway” is to be judged relative to the neutral fund’s rate, which estimate of the neutral rate is relevant? Is it the current neutral rate, which Yellen estimates as being near 2% in nominal terms, or is it FOMC participants’ median estimate of the longer-run neutral rate (about 3% in nominal terms)? Indeed, is it a moving target? Yellen said the current neutral rate will be converging toward its long-run value by the end of 2019. Under both our call for the fund’s rate and participants’ median dots, the fund’s rate would reach 2% in the middle of next year and 3% by late 2019.
If one interprets “well underway” as being relative to the current neutral rate, then the end of the current policy would be more imminent. Indeed, the dots have the fund’s rate reaching 1¼ % to 1½% by the end of this year, which would be nearing the current neutral rate. By contrast, if the standard for “well underway” is the estimated long-run neutral level of the fund’s rate, the fund’s rate is not expected to reach that level until the end of 2019. That might suggest a later beginning to the end of reinvestment. However, the estimate of 2% for the current nominal neutral rate has been with us for years, and the neutral rate is likely to be closer to 2% than 3% through 2018. Indeed, even the prospect of a rise to 3% by 2020 at this point is speculative. So we expect the Committee will be guided more by the current estimate of the neutral rate when deciding when to end the current reinvestment policy.
Indeed, this view is supported by recent remarks by President Williams: “We’re not quite there to well underway. But I would expect that assuming the economy progresses as I expect and we raise interest rates a few more times this year, that it will be closer towards the end of this year to be ready to start that process of normalization of the balance sheet.” President Mester also said she “would be comfortable” changing the reinvestment policy this year. While most FOMC members have not provided quantitative assessments of “well underway,” President Harker said “well north of 1%.” When pressed on what “well north” meant and was offered a range of 1% to 1½%, he said, “somewhere in that range, or maybe 1½%.”
Subject to Acceptable Momentum and Absent Material Downside Risks
Chair Yellen said at her press conference in December that (bolding is our emphasis):
There’s no mechanical rule about what level of the federal funds rate we might deem appropriate to begin that process. It’s not something that only depends on the level of the federal funds rate. It also depends on our judgment of the amount of momentum in the economy and possible concerns about downside risks to the economy.
President Harker gave a similar comment in his remarks on the “well underway” language (bolding is our emphasis): “That number should not be a trigger or a target. It really is saying what’s the momentum of the economy. Once I feel like the economy continues on this path of strengthening and we’re solidly in that zone, then we can stop reinvestment” (our emphasis).
The End of the Current Reinvestment Policy is Drawing Near
We see the FOMC’s guidance on both “well underway” and “momentum” as being consistent with an end of the reinvestment policy after an increase in the fund’s rate to about 1½%, conditional on evidence of sufficient momentum in the economy and the absence of substantial downside risks.
This interpretation of the guidance suggests that we are now approaching the end of the current reinvestment policy. If the economy performs as anticipated by FOMC participants and there are two more funds rate hikes this year—an outcome consistent with the median 2017 dot from the March meeting—then we would expect to see an announcement of the end of the current reinvestment policy later this year, and likely not later than early next year. Ending the current reinvestment policy by December would be consistent with the FOMC skipping a rate hike that otherwise might have occurred in December, given that the end of reinvestment would be expected to result in some tightening of financial conditions. Indeed, this is likely one reason why many participants believe a total of three hikes, rather than four, is appropriate this year.