On Wednesday, September 20th, the Fed left interest rates unchanged but FOMC members signalled they still expect one more hike by year end despite a recent bout of low inflation. The big news, however, is on the beginning of the reduction of the huge Fed’s balance sheet after three successive waves of quantitative easing. Indeed, as expected by the markets, the Fed will start in October of this year to reduce its c. USD 4.5 trillion in holdings of Treasury bonds and mortgage-backed securities.

In greater detail, the U.S. central bank will initially cut up to USD 10 billion per month from the amount of maturing securities it reinvests. The limit on reinvestment is scheduled to increase by USD 10 billion every three months to a maximum of USD 50 billion per month. This maximum amount should be reached by October 2018 but the Fed will remain flexible in case of worries. With these assumptions, the U.S. central bank will reduce the size of its asset stock pile by about USD 1.4 trillion over the next several years (see chart below) as it seeks to restore a normal environment for monetary policy, according to the poll of Wall Street’s top banks taken after the Fed’s latest policy meeting.

On Fed fund rates, the outlook for the next few years remained unchanged in the Fed’s latest projections, with three hikes envisioned in 2018, two hikes in 2019 and one hike in 2020 (see chart above). However, FOMC members lowered again the estimated long-term “neutral” interest rate from 3.0% to 2.75%, reflecting concerns about overall economic vitality. At the end of the day, the gradual monetary policy normalization should bring Fed funds rates in a range between 2.75% and 3.00% by 2020.

Market reactions were mixed. Indeed, U.S. bond yields rose (U.S. benchmark 10-year Treasury note yields rose to c. 2.3%, its highest point since the beginning of August), pushing up the USD, notably vis-à-vis the EUR, from c. 1.20 to less than 1.19. However, benchmark stock indexes did not change significantly.

Turning to economic conditions, forecasts for economic growth and unemployment for next year and beyond were unchanged. Indeed, real GDP is expected to grow at a rate of 2.4% in 2017, 2.1% in 2018 and 2.0% in 2019. The unemployment rate is forecast to remain at 4.3% this year before falling to 4.1% next year and is expected to remain there in 2019. Concerning consumer prices, inflation is expected to remain under the Fed’s target of 2.0% through to 2018 before hitting its target in 2019.

All in all, a December rate hike is still on the table and the Fed seems to be ready to slim down its huge balance sheet size. A few months from the end of her mandate, Janet Yellen had a lot to do. Indeed, she had to manage the end of the tapering initiated at the end of 2013. Then, she started very cautiously to rise Fed funds rates and continued the normalization cycle by starting to reduce the Fed balance sheet size. All this, without jeopardizing financial stability…


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