The Federal Open Market Committee faces a big test this week – can it announce the start of its balance sheet reduction operation without sparking something like a taper tantrum? This is one of the key meetings of the year as the monetary policy statement will be accompanied by economic projections and a press conference with chair Janet Yellen.

In summary:

Markets expect the Federal Reserve will set out a path for reducing its balance sheet and confirm it still intends one more interest rate hike this year.

Balance sheet reduction is likely to be very slow and cautious.

Inflation projections likely to be revised lower, which could test the market’s faith in the Fed hiking again this year and question longer-term rate projections.

Here is what to watch in more detail:

Balance Sheet

The big focus is the balance sheet; specifically when and how it reduces the $4.5 trillion in bonds and mortgage backed securities currently on its books.

Between 2008 and 2014, the Fed carried out bond buying and maturity extension programmes which resulted in purchases of $4.5 trillion in securities. The former loaded up the balance sheet while the latter extended the average duration of those securities from 5.2 years to 5.9 years and increased ten-year equivalents (TYE) from about $330 billion to $2.8 trillion.

Once it stopped buying new assets, the Fed kept those already on its books by rolling over maturing Treasury securities and reinvested payments from mortgage-backed securities. These actions continue to suppress demand in the market for bonds, keeping a lid on yields.

To begin with, the Fed will take baby steps. It is expected to slowly raise the limit on the amount of runoff allowed each month, starting at an estimated $10bn a month. It is likely to use this meeting to pre-announce the beginning of balance sheet reduction, which ought to ease the transition. It will not sell Treasuries outright, but simply allow them to roll off rather than re-investing the proceeds. It is also expected to leave mortgage backed securities alone to reduce any impact on homeowners.

Nevertheless, reversing QE is not without risks. This is an unprecedented move although with the announcement largely expected it in itself is not currently expected to exert a big impact on the markets. However the pace and scale of the roll-off process is unknown, meaning there is potential for some volatility in Treasury yields leading up to the announcement and after. We do not yet know what the Fed’s final target for its balance sheet is but it is unlikely that we will find out exactly, however the pace and scale of the reduction will offer some indication and this unknown could upset markets.

Ten-year yields now trading around 2.2% seem to have bottomed out after sinking below 2.05% earlier this month.

Dot Plot

A third hike in 2017? Markets do not expect the Fed to raise short term rates this week, and increasingly it is seen as not hiking again this year. However, policymakers have maintained expectations for a third hike to happen before the year is out and they are expected to reaffirm this stance.

With this meeting featuring economic projections, the Fed’s so-called dot plot will be pored over for any signs that policymakers are changing their opinion on the path of rates.  While a fissure seems to be opening up within the FOMC between hawks and doves, the median forecast is likely to indicate another quarter point hike this year, almost certainly held back until December.

However, the dots may be less relevant than previously with question marks over the composition of the FOMC still lingering. Yellen’s reappointment remains a big doubt, which coupled with the departure of no2 Stanley Fischer means the make-up of the Fed in 2018 could be a lot different and therefore leaves open the possibility that dots will change with the arrival of new members.

 Further out, the median dot could come down a touch given the recent inflation data. This meeting will offer the first glimpse of where the Fed sees interest rates in 2020.

The FOMC is still likely to veer towards saying weaker inflation is temporary. This view gains support from the CPI inflation data which is showing more signs of life. CPI rose 0.4% month-on-month August to produce an annual gain of 1.9%. Core CPI rose 0.2% m/m for a 1.7 y/y gain. 

Inflation and unemployment

Of crucial concerns is how the FOMC’s opinion is shaping up regards low unemployment combined with low inflation. Whilst the statement is likely to stick with the line that the FOMC is monitoring inflation closely, Janet Yellen will have a chance to elaborate on the Fed’s thinking in the post-statement press conference and her comments will be important to guiding the markets.

The dots may make it obvious how policymakers see inflation. In terms of the economic projections, market participants will watch closely how policymakers view how inflation has progressed since the last economic projections were released in June.  Then, policymakers downgraded their forecast for core inflation in 2017 from 1.9% in March to just 1.7%.

PCE inflation has since deteriorated further. At its June meeting (when the last projections were released), the Fed was looking back at PCE inflation at 1.8% in March and 1.7% in April. Since then the rate of price growth has fallen to 1.4% in June and July after slipping to 1.5% in May. Core PCE inflation has fallen from 1.6% in Mar/Apr to 1.4% in July.

With the core PCE figure falling since June there is a chance that the Fed will further downgrade its inflation forecasts this year. This poses one of the big tests for markets as if the dot plots remain unchanged it will fuel further uncertainty about how the Fed views the risks to the economy. Like in June, inflation being revised lower combined with a steady dot plot ought to signal that the Fed prefers to see the risks to financial stability outweighing the risks of missing its inflation target. Such a move would confirm that the Fed is not yet significantly worried about the lack of inflation and suggest the third hike this year is still on.

Minutes from the July meeting highlight the split regards unemployment and inflation:

“Some participants expressed concern about the recent decline in inflation, which had occurred even as resource utilization had tightened, and noted their increased uncertainty about the outlook for inflation. They observed that the Committee could afford to be patient under current circumstances in deciding when to increase the federal funds rate further and argued against additional adjustments until incoming information confirmed that the recent low readings on inflation were not likely to persist and that inflation was more clearly on a path toward the Committee’s symmetric 2 percent objective over the medium term. In contrast, some other participants were more worried about risks arising from a labor market that had already reached full employment and was projected to tighten further or from the easing in financial conditions that had developed since the Committee’s policy normalization process was initiated in December 2015. They cautioned that a delay in gradually removing policy accommodation could result in an overshooting of the Committee’s inflation objective that would likely be costly to reverse, or that a delay could lead to an intensification of financial stability risks or to other imbalances that might prove difficult to unwind."

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