The Federal Reserve Board decided to raise the fund rate by 25 basis points, carrying the total rate to 1% to 1.25%. Normalization of the balance sheet is expected to start by the end of 2017.
Inflation stayed down despite the low interest rate environment. Nevertheless, the economy showed positive signs through household spending improvement, consumer satisfaction and growing business investment.
The Fed expects the interest rate to rise to 3% by 2019 while inflation is expected to stabilize around 2%. Increasing rates and balance sheet unwinding do not bode well for equity markets. Nasdaq Composite, Standard & Poor's 500 and Dow Jones were down 0.77%, 0.37% and 0.16% Thursday afternoon.
Economic recap
Janet Yellen, the chairman, mentioned that household spending rebounded including continuing improvement in the job market; consumer sentiment also stayed high. She further noted that business investment continues to increase and that the Federal Reserve expects the economy to expand moderately over the next few years. She was also quick to point out the high uncertainty of the economic outlook.
Low Inflation remains persistent
Despite lower rates and expansionary policy measures, inflation continues to persist at lower levels. The Fed cited one-off reductions such as wireless telephone services and prescription drugs for lower-than-expected inflation. Note that the 12-month change in the price index for personal consumption expenditures was 1.7% in April. The Fed expects the rate to increase and stabilize around 2% during the next couple of years.
Interest rates are expected to stay low
Although the fund rate was increased, Yellen emphasized the need to maintain neutral rates that are neither expansionary nor contractionary. She also cautioned that the neutral rates are not similar to what they were in previous decades.
“Because the neutral rate is currently quite low by historical standards, the federal funds rate would not have to rise all that much further to get to a neutral policy stance.”
The Fed forecasts that the fund rate will rise from 1.4% at the end of this year to 2.9% by the end of 2019, which is also the long run value for the policy rate.
The balance sheet problem
Last month the Federal Reserve revealed its plan to normalize the balance sheet through putting a cap on reinvestment and gradually increasing that cap. During this meeting the Fed pointed out that the process may start as early as the end of this year. Regarding reduction in reinvestments, the Fed noted:
“Initially, these caps will be set at relatively low levels –Â $6 billion per month, 5 for Treasurys and $4 billion per month for agencies. So any proceeds exceeding those amounts would be reinvested. These caps will gradually rise over the course of a year to maximums of $30 billion per month for Treasurys and $20 billion per month for agency securities and will remain in place through the normalization process.”
The chair also pointed out that reduction in the balance sheet, or discontinuing reinvestments, will result in the reduction of reserve balances in the banking system.
Note that reduction in reserve balances will limit commercial financial institutions’ ability to deploy the reserve funds, which can have a negative impact on financial markets.
Yellen also assured that the normal level of the balance sheet will be higher than it was before the financial crises of the last decade. The Fed also mentioned that expansionary policy can be used again if the economy takes a turn for the worse.
Implications
A gradual rate hike will put downward pressure on inflation, which can lead to stagnation in economic growth. As it can be seen that lower rates didn’t have much impact on increasing the inflation rate, rate hike can cause deflationary effect that can negatively affect economic growth.
Further, the rise in policy rate will also have a marginal effect on the Fed’s balance sheet. A rate hike contributes to the reduction in the value of securities. The Fed has to spend less for reinvestment. Overall, an increasing rate will effectively start to reduce the Fed’s reinvestment.
Regarding balance sheet, a gradual decrease will have a gradual negative impact on equity markets as the Fed retakes the funds from open markets.
A corresponding decline in reserve balance will limit the commercial financial sector’s ability to stay generous, which will impact asset prices.
Bottom line
It all boils down to the fact that an increasing rate and declining balance sheet will impact capital markets negatively, and investors should be cautious in investing as current market valuation might not support upcoming rate hikes and balance sheet reductions.
