Last Wednesday, the Federal Reserve (Fed) announced it would raise the fed funds rate by a quarter point – its fourth rate hike since starting to tighten in December 2015. This was very much expected and created no surprises for investors. But the far bigger news coming out of the Federal Open Market Committee (FOMC) meeting is that the Fed released its plan to normalize its balance sheet. And with that, the Fed has finally addressed the elephant in the room.
According to the Oxford English Dictionary, The New York Times was the first to publish the term “elephant in the room.” In a 1959 article, the Times wrote, “Financing schools has become a problem about equal to having an elephant in the living room. It’s so big you just can’t ignore it.” Since then, the term has been used to describe an obvious problem or risk that people would prefer not to address.
Through the years, there have been a number of proverbial elephants in the room, such as how to close the Social Security funding gap and how to handle the rising costs of higher education and the resulting student loan crisis. Since 2009, I would argue that the biggest pachyderm has been the Fed’s balance sheet. By the time the Fed completed three phases of quantitative easing (purchasing securities to lower interest rates and stimulate the economy), it had increased its balance sheet from approximately $800 billion to well over $4 trillion.1 Since the start of this highly controversial policy, economists and investors have fretted over how it would be unwound – thereby “normalizing” its balance sheet – and what the potential impact of that unwinding might be.
When assessing the possible impact of monetary policy tools, I would argue that balance sheet normalization has far greater potential to affect markets than rate hikes. After all, this isn’t the Fed’s first rodeo when it comes to orchestrating a rate hike cycle – but that is not the case for large-scale balance sheet normalization. This makes it somewhat surprising that the Fed released its plan for balance sheet normalization at its June meeting.
In past communications, the Fed has made it clear that it would wait until rate hikes are well underway and the economy has sufficiently strengthened before starting to normalize the balance sheet. The fed funds rate is still very low in relative terms, and we’ve actually received some weak economic data recently, including a tepid labour report for the month of May and lower inflation. The Atlanta Fed GDPNow indicator continues to ratchet down its projection for second-quarter GDP growth, from well over 4% in late April to 2.9% – still a very respectable number but certainly not as robust as earlier forecasts. And perhaps most importantly, chances for fiscal stimulus any time soon from tax reform and infrastructure spending seem to be diminishing by the day.
Why address the elephant now?
So why did the Fed release its plan now? Certainly there is the desire to be as transparent as possible – something that Minneapolis Fed President Neel Kashkari, among others, has advocated. After all, this lesson was learned from the “taper tantrum” of 2013 when then-Fed Chair Ben Bernanke surprised markets with somewhat offhand comments that the Fed could start tapering its asset purchases later that year.
It is also likely that the Fed was in something of a hurry to get out plans for balance sheet normalization in advance of any changes in FOMC membership. With information reported in early June about two likely nominees for the FOMC, the Fed was probably interested in getting its plans in place and well-publicized before any new, possibly more hawkish members joined. It is much harder to divert from a plan once it has been agreed upon and made public, even if implementation probably will not start for a while. It seems that Chair Yellen is incredibly mindful of the potential risks that could be created by unwinding the balance sheet – and so wants to proceed as slowly and carefully as possible. Much like removing an actual elephant from your living room.
Chair Yellen may be well-suited for this challenge. After all, her thesis advisor in graduate school was the economist James Tobin, who served on the Council of Economic Advisers in the Kennedy administration. Mr. Tobin is perhaps best known for “Tobin’s Q,” a financial ratio. However, he may ultimately be far better remembered for his role as an advocate of quantitative easing as a monetary policy tool. As former Chair Bernanke noted in a speech on monetary policy since the onset of the crisis, “Tobin suggested that purchases of longer-term securities by the Federal Reserve during the Great Depression could have helped the U.S. economy recover despite the fact that short-term rates were close to zero.” Mr. Tobin recognized the power of the Fed’s balance sheet long before most did – and Chair Yellen seems to be just as mindful of its power.
Removing the elephant – slowly
And so, not surprisingly, the balance sheet normalization plan crafted under Chair Yellen is as careful and cautious as possible. The Fed will taper reinvestment ever so slightly to start with:
- Treasuries, which represent roughly 55% of the Fed’s balance sheet, will see a tapering of reinvestment initially capped at $6 billion per month. The cap will increase by an additional $6 billion at three-month intervals until it reaches a maximum cap of $30 billion per month, where it will remain.
- Tapering reinvestment will be even more modest for mortgage-backed securities, which represent about 40% of the Fed’s current balance sheet. The initial ceiling on the mortgage-backed securities portion of the Fed’s balance sheet that will not be reinvested is $4 billion. That cap will increase by $4 billion in three-month intervals until it reaches a maximum cap of $20 billion per month, where it will remain.
In addition, the Fed is essentially taking the “data dependent” criteria it uses for the fed funds rate and is extending it to balance sheet normalization as well. In the Addendum to the Policy Normalization Principles and Plans released by the FOMC last week, the Fed notes: “… the Committee would be prepared to resume reinvestment of principal payments received on securities held by the Federal Reserve if a material deterioration in the economic outlook were to warrant a sizable reduction in the Committee’s target for the federal funds rate.” In other words, the Fed wants to retain as much flexibility as possible and reserve the right to temporarily halt balance sheet normalization if necessary. Resuming reinvestment is not something that could be triggered lightly – it would require a significant deterioration in the economic outlook. However, it means the Fed is not on an entirely pre-set course.
What does normalization mean for future rate hikes?
It is that cautiousness that raises the possibility that the Fed may hit the “pause” button on rate hikes while it ensures that markets have successfully digested the start of balance sheet normalization. That’s perhaps why fed funds futures currently indicate a slightly lower chance of a rate hike in December 2017 than it did just a week ago. So if, for example, the Fed announces the start of normalization in September, it is possible that there will be no more rate hikes this year – especially if economic data remains tepid.
I don’t believe this is the base case scenario. I agree with my colleagues at Invesco Fixed Income, who expect to see one more rate hike this year – but we will need to follow the balance sheet normalization process and the economic data closely. After all, with a data-dependent fed funds policy, it is hard to predict where the fed funds rate will be in six months.
In short, the Fed’s plan for balance sheet normalization seems poised to ensure the least possible disruption to markets. The Fed’s goal of having balance-sheet normalization operate in the background, with the focus on the fed funds rate as the primary policy tool, seems likely to come to fruition.
Takeaways for investors
We will want to follow the situation closely given how powerful a tool the Fed’s balance sheet is, and given that there are many moving parts impacting the U.S. economy and capital markets – not the least of which is geopolitical risk. That means investors should talk to their financial advisors about adequate exposure to stocks outside the U.S. in order to be well-diversified. Within fixed income, investors should consider investments that can provide adequate income potential given that relatively low rates are likely to persist. Finally, investors looking for further diversification may consider increasing exposure to alternative asset classes, such as real estate and commodities, which are not correlated with stocks.
Looking ahead, in addition to some housing data, we will be hearing from a bevy of Fed speakers this week. Investors should look to them for additional clues on the timing of balance-sheet normalization and rate hikes and of course their views on the current state of the economy.