Fed Leaves Rates Unchanged, Begins QE Unwind In October

by Ike Obudulu Posted on September 20th, 2017

After months of preparation and telegraphing their plan to markets, the Federal Reserve took the first tentative steps Wednesday to unwind its history making economic stimulus. The policy making Federal Open Market Committee, FOMC, today announced the start, from October, of the reversal of quantitative easing and the reduction of its US$4.5 trillion balance sheet. Most of those assets consist of the Treasurys and mortgage-backed securities it acquired under a program known as quantitative easing, QE.

The Fed left its benchmark interest rate (currently between 1% to 1.25%) unchanged but hinted at one more rate hike this year if persistently low inflation rebounds. The Fed policymakers’ updated economic forecasts show an expectation for three more rate hikes in 2018, that is one fewer rate hike than initially forecast by 2019. The Federal Reserve reduced its outlook for inflation, cutting its expectation from 1.7 percent this year to 1.5 percent, and from 2 percent to 1.9 percent in 2018.

The central bank intends to begin the balance sheet draw-down slowly, with monthly reductions of just US$10 billion. The cutbacks will come even as the European Central Bank and the Bank of Japan continue to add to their holdings.

To avoid spooking investors, the Fed’s plan for shrinking its balance sheet is so gradual that the total would remain above $3 trillion until late 2019.

The policymaking Federal Open Market Committee stated only that the “balance sheet normalization program” as outlined in June will commence next month.

Some economists say they think the figure could end up around $2.5 trillion, still far above the $900 billion the Fed held in its portfolio in pre-situation days.

The issue of when and how the Fed will manipulate its main policy lever, its target for short-term rates, in coming months is less clear. After leaving its benchmark rate at a record low for seven years after the 2008 situation, the Fed has modestly raised the rate four times since December 2015 to a still-low range of 1 percent to 1.25 percent.

Treasury prices fell and yields across the board rose on Wednesday after the Federal Reserve’s policy statement revealed most of the central bank’s rate-setting committee wanted to see another rate increase in 2017, despite tepid inflation data in the past few months.

Taken together the asset-portfolio reduction and further increases to interest rates are likely to tighten monetary policy, pushing borrowing costs up and encouraging traders to sell existing bonds in anticipation of richer yielding issuance in the future.

The 2-year Treasury note’s yield TMUBMUSD02Y, +2.93% climbed 4 basis points to 1.442%, the highest since Nov. 2008. The 10-year Treasury note yield TMUBMUSD10Y, +1.02% rose 3.7 basis points to 2.276%, the highest in five weeks, while the 30-year bond yield TMUBMUSD30Y, -0.31% rose a basis point to 2.821%.

Bond prices move in the opposite direction of yields.

The Dow Jones Industrial Average DJIA, +0.19% rose 41.79 points, or 0.2%, at 22,412.59, supported by sharp gains in shares of McDonald’s Corp. MCD, +1.56% and Pfizer Inc. PFE, +1.52% Apple Inc. AAPL, -1.68% shares led Dow laggards, down 1.7%, on negative news.

The S&P 500 index SPX, +0.06% meanwhile, finished up 1.59 point, or less than 0.1%, at 2,508.24, after briefly touching its own fresh intraday day record at 2,508.85. Financials and industrials led the day’s advances, while a 1% tumble in the consumer-staples sector, underpinned by a drop in shares of General Mills Inc. GIS, -5.80% pressured the broad-market gauge.

The Nasdaq Composite Index COMP, -0.08% ended down 5.28 points, or less than 0.1%, at 6,456.04.

The fate of the strategy has huge implications for investors. The move reflects a strengthened economy and could mean higher rates on mortgages and other loans over time. While the economic effects of QE are hard to quantify, the policy has had an outsized impact on financial markets.

By buying up bucketloads of bonds and quintupling its balance sheet, the US central bank pushed long-term yields down and equity values up. That has led to criticism that it distorted markets and unduly favored wealthy shareholders.

QE, as practiced in the United States, was three separate programs. The first, initiated in late 2008 at the height of the situation, was heavily weighted toward the purchase of mortgage-backed securities.

Launched the day after Republicans scored big wins in the 2010 congressional elections, QE2 was condemned by a host of lawmakers, including then Indiana representative and now Vice President Mike Pence, who worried about an outbreak of inflation that never materialized.

The Fed began QE3 two years later, eventually promising to continue to buy MBS and Treasuries until the labor market outlook improved substantially.

Photo: Janet Yellen, US Federal Reserve Chair

Quantitative easing is a massive expansion of the open market operations of a central bank. It’s used to stimulate the economy by making it easier for businesses to borrow money. The bank buys securities from its member banks to add liquidity to capital markets. This has the same effect as increasing the money supply. In return, it the central bank issues credit to the banks’ reserves to buy the securities.

Where do central banks get the credit to purchase these assets? They simply create it out of thin air. Only central banks have this unique power. This is what people are referring to when they talk about the Federal Reserve “printing money.”

The purpose of this type of expansionary monetary policy is to lower interest rates and spur economic growth. Lower interest rates allow banks to make more loans. Bank loans stimulate demand by giving businesses money to expand. They give shoppers credit to purchase more goods and services.

By increasing the money supply, QE keeps the value of the country’s currency low. This makes the country’s stocks more attractive to foreign investors. It also makes exports cheaper.

Japan was the first to use QE, from 2001 to 2006. It restarted in 2012, with the election of Shinzo Abe as Prime Minister.

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