 | Rate Hikes Approaching |
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| Posted Under: Government • Research Reports • Fed Reserve • Interest Rates |
We count five major takeaways from today's activity at the Federal Reserve.
First, quantitative easing (QE) still looks on track for winding down at the end of October. As expected, the Fed announced it would cut its purchases of Treasury securities and mortgage-backed securities to $15 billion in October and expects to announce an end to QE at the next meeting, which is October 29th.
Second, the median view among Fed officials is for a slightly faster increase in short-term rates. Back in June, the consensus was for the top of the federal funds target range to be 1.25% at the end of 2015; now it's 1.5%. Previously the consensus was around 2.5% for the end of 2016, now it's 3%. As a result, it now looks like the Fed will start raising rates by April 2015, perhaps even as early as the first quarter. To confirm this, look for the Fed to dump the "considerable time" language later this year.
Third, once it starts raising rates, the Fed will try to control the federal funds rate by using the interest it pays banks for holding excess reserves. It will also use reverse repos to help control the funds rate, but only as much and as long as needed. The Fed says it won't use reverse repos for other purposes.
Fourth, the Fed isn't going to outright sell securities from its portfolio to unwind its bloated balance sheet. After starting to raise the funds rate, the Fed will eventually allow its balance sheet to shrink in a passive way, by letting securities gradually mature without full reinvestment. The Fed is particularly reluctant to sell mortgage-backed securities (MBS), but may eventually do so several years down the road to clean up some long-dated securities on its books that won't mature anytime soon. Long-term, the Fed intends to go back to holding almost all Treasury securities, not a large portfolio of MBS.
Last, where there's smoke, there's fire. Two Fed officials dissented from the statement, both Philadelphia Fed Bank President Charles Plosser and Dallas Bank President Richard Fisher. More importantly, both dissents were from hawks, which suggests that if the Fed makes any changes in policy or projections at the next couple of meetings, it's more likely to get more hawkish than more dovish.
The Fed also made some minor changes to the language in its statement, noting that the unemployment rate is little changed since the last meeting and the economy is expanding moderately after the downside surprise in Q1 and sharp rebound in Q2.
The bottom line is that the Fed has been and will remain behind the curve. Nominal GDP – real GDP growth plus inflation – is up 4.2% in the past year and up at a 3.7% annual rate in the past two years. A federal funds target rate of nearly zero is too low given this growth. It's also too low given well-tailored policy tools like the Taylor Rule.
Hyperinflation is not in the cards; the Fed will keep paying banks enough to keep the money multiplier depressed. But, given loose policy, we expect gradually faster growth in nominal GDP for the next couple of years. In turn, the bull market in equities will continue to prevail and the bond market is due for a fall.
Brian S. Wesbury, Chief Economist
Robert Stein, Dep. Chief Economist
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