Federal Reserve officials have laid out a path of steady interest-rate hikes through 2019. But there seems to be a fly in the ointment: the central bank may have to take a six-month pause from raising rates when it begins the process of shrinking its massive $4.5 trillion balance sheet.
To date, Fed officials have not provided a detailed plan for the balance sheet, and the idea of a pause is not reflected in the central banks so-called dot-plot of the likely path of interest rates.
“Fed officials have raised more questions than they have answered,” said Tom Simons, an economist at Jefferies.
New York Fed President William Dudley first brought up the possibility of a delay in rate hikes last week.
“If and when we decide to normalize the balance sheet, we might actually decide at the same time to take a little pause in terms of raising interest rates,” said New York Fed President William Dudley in an interview on Bloomberg TV on Friday.
At the moment, the Fed is reinvesting the principal payments of maturing securities to hold its balance sheet relatively stable. The first step in shrinking the balance sheet is to allow maturing securities to run off the Fed’s balance sheet.
Dudley said he would not be surprised if the Fed gradually ended its reinvestment of principal “sometime later this year or sometime in 2018.” He said the Fed wanted the process to be “running in the background” and be done in a way that is “not a big deal for markets.” This might be accomplished by continuing to roll over some part of the Fed’s maturing securities, he said.
The Fed purchased Treasurys and mortgage-related assets in the wake of the financial crisis in order to push down long-term interest rates. So the anticipation and actual announcement of the Fed shrinking its balance sheet is likely to drive rates higher.
Simons said Dudley had never previously mentioned 2017 as a possible start to shrinking the balance sheet. Dudley is seen as a key voice at the central bank because of his close ties to Fed Chairwoman Janet Yellen.
For her part, the Fed chief has said does not want to start shrinking the balance sheet until the process of raising interest rates is “well underway.” But at her press conference in mid-March, she dodged when asked to define this term, saying only the central bank wanted to have “confidence in the economy’s trajectory” before starting to shrink the balance sheet.
Lou Crandall, chief economist at Wrightson ICAP, said he doubted the Federal Open Market Committee as a whole was close to reaching consensus on the timing.
“Our sense continues to be that the Fed is in the early stages of analyzing its balance sheet normalization options,” Crandall said in a note to clients.
So far, Simons said, comments from Fed officials has raised “more questions than answers” in their comments. For instance, he noted the “dot plot” is not structured for two policy levers.
Fed officials “can’t give a simplified forecast for monetary policy in the future,” he said.
The Wall Street Journal reported the balance sheet was discussed during the March 14-15 FOMC meeting. The minutes of the meeting will be released Wednesday, and Fed watchers hope to learn more about the internal debate.
Krishna Guha, vice-chairman of Evercore ISI and a former Fed official, said he interpreted Dudley’s comments as indicating the Fed will initiate balance sheet roll-off in December after two more hikes in June and September. He said the pause in rates could extend until June 2018.
Simons said he thought 2017 was too early for the Fed to stop reinvestment.
“If 2017 is a realistic target for changes in…reinvestment policy, the FOMC needs to kick the preparation process into a higher gear,” he said.