The FED moves cautiously in slowly bidding up the Federal fund rate for the second time during 2017 bring it to 1% and 1.25%. Federal Open Market Committee cited mixed economic data as the reason for this measured increase. In addition, FED’s now plans to wind down its $4.5 trillion balance sheet, by reducing its holding of government agency debt, Treasury, and mortgage-backed securities. Further, the reinvestment of payments would be actuated after exceeding of the 6 billion dollars per month cap. A cautious statement has emanated from the FED because economic data has not been overly convincing. For example, the 1st quarter GDP was disappointing; inflation targets remain unmet with inflationary pressures rather soft, while payroll gains have been slower than in the recent past. Unarguably the economy is reaching full employment levels, at 4.3% unemployment rate, as this has allowed for a steady increase in household spending; business investment has also remained on a positive trend, posting an expansion. The committee has made a due note of the fact that both the Consumer Price Index (CPI) Personal Consumption Index (PCI) have remained below the target threshold of 2%, posting a reading of 1.5% and 1.9% respectively. While the FED has concurred that the risk to the economy remains balanced, the inflationary target can only be met, at best, in the medium term while GDP growth rate to reach 2.2% in 2017. Long-run estimates of the unemployment rate are 4.6% and FED officials have now lowered their expectation of long-term inflation to 1.7%, which is a morale deflator.
Some review the recent FED move as a “hawkish surprise” because the shrinking of the balance sheet and rising interest rate would lead to a further flattening of the yield curve. The term structure is already on a negative slope, with the difference between the long-term US treasury yields and short-term Treasury yields approaching precarious levels. In addition to the payment proceeds reinvestment over the $6 billion cap, the FED has also assigned a cap on mortgage debt at $4billion, and a commitment has been shown for the runoff program to continue until the size of the balance sheet is brought to a manageable level of $2-$2.5 trillion. So overall with some monetary tightening at the behest of wobbly economic data, and term structures not very convincing, it remains to be seen when the economy takes a hiatus from its recent upward trajectory, as the current trend of rate heightening is set to continue. The dot-plot, which charts an expectation of FOMC of where the federal fund will be called for another increase in 2017, taking the rate to at least 1.4%. In addition, with only 1 dissenting voter, Neel Kashkari of Minnesota, the FED funds futures market is giving a 35% probability of an increase. While this process of normalization is set to continue, with the rate reaching 2.9% by 2019, below the long-run average of 3%, the ramifications could be excruciating, when we consider that GDP growth rate is at par with the pre-recessionary conditions of 2008. It was a quick reversal of growth rate that threw the economy into meltdown and with the term structure acting as an accurate leading indicator; is not the writing surely on the wall even for the average observer. The only question probably remains only of timing!!!!