The New Wave Diet: Cutting Treasuries and MBS

The Federal Reserve raised its benchmark interest rate last week to a range of 1 to 1.25 percent, in line with market expectations. The widely telegraphed move reflects the Federal Reserve’s confidence in the economy’s progress and a labor market that is inching closer to full employment. The FOMC was less sanguine on its expectations for inflation, a measure it has consistently forecasted incorrectly. In a statement published Wednesday, the FOMC predicted that headline PCE would rise by 1.6 percent this year, down from its 1.9 percent projection at the March meeting. The median forecasts for 2018 and 2019 were left unchanged at 2 percent. The dot plot, a measure of where the FOMC expects the Fed Funds rate to be in future periods, also remained intact, except for 2019, which saw a slight decline to 2.875% from 3.0% at the March meeting. In addition to adjusting its inflation forecasts, the FOMC slightly reduced its estimate for the lowest sustainable rate of long-term unemployment from 4.7 to 4.6 percent. This change, along with the downward revision to its 2017 inflation forecast, could give the Fed time to pause before hiking again in the coming months, especially if inflation is weak. Accompanying the decision to increase interest rates were details surrounding the Fed’s plan to begin tapering its balance sheet of more than $4 trillion of Treasuries and mortgage-backed securities later this year. While no start date was offered, the Fed did announce that it would initially shed $10 billion of securities a month for three months, divided 60-40 between Treasuries and MBS. It will then increase the pace by $10 billion a month every three months, maintaining the same division of assets, until it reaches $50 billion a month. While a swift retreat from asset purchases has the potential for market disruption, the schedule outlined by Chairwoman Janet Yellen indicates that the Federal Reserve intends to tread softly and maintain a steady pace of balance sheet normalization. 

Source: NYT, Bloomberg