Posted by on July 26, 2017 3:59 pm
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Categories: B.S. B+ bank of america Barclays Business central bank Congress Core CPI CPI Deutsche Bank Economy FED Federal funds rate Federal Open Market Committee Federal Reserve System Financial services goldman sachs Inflation Inflation targeting Jim Reid Monetary Policy money Morgan Stanley Open market operation Phillips curve RANSquawk Reuters SocGen Testimony unemployment US Federal Reserve

Unlike the June Fed meeting, the FOMC announcement at 2pm today is expected to be an uneventful affair: as DB’s Jim Reid pointed out earlier, “given its late July and given the Fed will likely announce an end to balance sheet reinvestment in September (starting from October), this could be a relatively dull meeting.”

Big picture: the FOMC is expected to keep interest rates unchanged at this meeting at 1.00%-1.25%, after hiking last month. According to RanSquawk, all analysts surveyed by Reuters expect the Fed to keep rates unchanged. The market agrees with them: Fed Funds currently price in a 0% chance of a rate hike today.

And, as BofA notes, the market is clearly not expecting any Fed balance sheet reduction today either:

With no press conference from the Fed Chair Yellen or Summary of Economic Projections released at this meeting, focus will be on the accompanying statement for the Fed’s views on inflation and any timing on the beginning of normalising the balance sheet.

Indeed, there are just two things to watch in today’s press conference-free FOMC statement: (1) any hints that Fed balance sheet reduction will be announced in September and (2) adjustments to the language discussing the recent disappointment in the rate of inflation (after 4 consecutive CPI misses).

  • On inflation: the previous statement said the Fed still expects inflation (PCE) to stabilise around the Committee’s objective of 2.0% in the medium term, although on a 12-month basis was still expected to remain below 2.0%. Deutsche Bank say the Fed “will need to acknowledge the further decline in inflation since the June meeting” but should keep their medium-term view unchanged. Since the last meeting, Yellen spoke to Congress and although she noted that it was mostly temporary factors holding inflation down, she said she “recognised the dangers of persistently undershooting the Fed’s 2.0% target.”
  • On the balance sheet: The Fed appears to be committed to shrinking its balance sheet, with most analysts expecting an announcement by the end of the year. The Fed’s most recent forward guidance has suggested that the start of balance sheet normalisation will be implemented in 2017, provided the economy evolves in line with expectations. Most analysts are not expecting an announcement of the start date of balance sheet normalisation at this meeting but there could be a tweak in the language. HSBC say the Fed could announce that they will begin balance sheet normalisation “relatively soon”, opening the door for a September announcement, to begin shortly after. In her semi-annual testimony to Congress, Yellen said she “expects balance sheet reduction to begin soon”.

In terms of explicit phrasing changes to the FOMC statement, according to BNP’s Paul Mortimer-Lee – who has been relatively bearish on the US economy recently – one of most important potential changes to the FOMC statement will be whether the Fed drops “somewhat” in its description of core inflation below target. It would be a “big sift if dropped and would show Fed losing faith in its own projections.” Mortimer-Lee also lays out “what could be a shocker at FOMC? 1 rate hike – close to impossible; 2 announce balance sheet adjustment <20%;  hoist white flag on inflation = 25%

In similar vein, Citi thinks that it is more likely than not that the revised statement will use a phrase like “relatively soon” to signal that the committee plans to announce balance sheet reduction in September.

“This should provoke little market reaction as (1) most clients we speak with expect such a change (2) Chair Yellen used this phrase in Congressional testimony two weeks ago (3) Fed balance sheet reduction related news has provoked little reaction from long end rates and currencies and (4) this is a marginal change from the current language: “The Committee currently expects to begin implementing a balance sheet normalization program this year.”

Citi concedes that even if there is no change to the balance sheet normalization language the bank’s call would “remain for a September balance sheet reduction announcement followed by a December rate hike.” The June FOMC meeting followed three significant downside misses to core CPI for March, April and May. June core inflation (received subsequent to the June FOMC) was stronger than March-June but still weak at 0.12% MoM.

In June the committee noted that inflation “declined recently” and “is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee’s 2 percent objective over the medium term.” It was noted that “the Committee is monitoring inflation developments closely.” This language still characterizes well the FOMC view of inflation, suggesting only small tweaks may be in order.

In the June press conference Yellen focused on the transitory nature of the slowing. But subsequently, Fed officials, including Chair Yellen, have been a bit more inclined to attribute some persistence to the slowdown in inflation. The medium term view of inflation returning to 2% has not changed substantially for the core of the committee. The July statement may acknowledge that risks to inflation are “two sided,” but we would be surprised to see, and take as dovish, any wavering in confidence that inflation will stabilize around 2 percent. Apart from inflation, the statement that “job gains have moderated” may be revised to indicate they remain robust.

* * *

Parsing the statement, Bank of America expects the following textual changes:

Paragraph 1: Current conditions

We think the language is likely to be tweaked to reflect the latest data. As such, we expect a more positive assessment about job growth given the strong gain in June, but a more cautious tone around household spending. The FOMC may also note the recent weakness in core inflation is *partly* a result of a few unusual reductions in certain categories of prices. As Chart 1 shows, even trimmed measures of core inflation have continued to slide, making it hard to argue the recent weakness is entirely transitory.

Paragraph 2: Economic outlook:

The FOMC is unlikely to change the characterization of economic activity or the labor market, in our view. We also think it will note that near-term risks to the economic outlook appear roughly balanced, as Chair Yellen reiterated at the semi-annual monetary policy testimony. On the inflation outlook, we expect them to note that inflation has remained subdued despite the low rate of unemployment. However, they are likely still to reiterate that they expect inflation to stabilize at the 2% target over the medium term. This would be a way of implying that the Phillips Curve relationship has weakened, as we demonstrate in Chart 2, but that Fed officials are still assuming that it is relevant.

Paragraph 3: Policy decision

We expect the FOMC to double down on the commitment to normalize the balance sheet. In the June statement, the statement read as “the Committee currently expects to begin implementing a balance sheet normalization program this year, provided that the economy evolves broadly as anticipated”. We think this will likely be changed to read that the Committee expects to begin implementing a balance sheet normalization program *soon*. This would, in our view, send a message that the FOMC is on track to announce the change at the September meeting. It is possible the FOMC goes a step further and explicitly signals the B/S normalization in September by stating the change will occur at the “upcoming meeting”.

It is also possible, although a low probability in our opinion, that the FOMC announces balance sheet normalization at the meeting tomorrow. Fed officials have been consistent in the view that the time has come to begin shrinking the balance sheet. They have also made it clear that it is data independent; low inflation will not take them off course from starting the process. They believe it will be a non-event in the markets when it begins and it will be able to continue on autopilot. As such, we think it is possible Fed officials do not see a reason to wait for the September meeting. This would come as a surprise to the markets, however, and it is not the Fed’s intention to deliver surprises.

* * *

Market reaction:

Overall, this meeting should not be a game changer as the Fed tend to communicate changes to policy relatively far in advance and there has been no indication that they will venture too far from the script at this meeting. Barclays say that “an announcement on balance sheet normalization in July would leave open the possibility of two additional rate hikes this year. This would likely send a more hawkish signal than warranted given the incoming data on activity and, in particular, inflation.”

What the Banks are saying:

Finally, courtesy of RanSquawk, here is a breakdown of what various sellside desks are expecting will be announced today: 

  • Goldman Sachs: We do not expect any policy changes at the July FOMC meeting and expect only limited changes to the statement, which will likely upgrade the description of job growth, but might also recognize that inflation has declined further. We think the statement is also likely to acknowledge that the balance sheet announcement is now closer to hand, and we continue to expect the FOMC to announce the start of it’s balance sheet normalization in September.
  • JPM: We expect no change in the funds rate target and no change in balance sheet policy (we think there is a ~20% chance for the Fed to begin the balance sheet normalization process at the Jul meeting). The policy guidance will likely signal an inclination to begin the normalization process in Sept but we don’t anticipate changes to the Fed Funds outlook. We expect the statement will sound more upbeat on the labor market, about similarly confident on growth, but more cautious on inflation.
  • Morgan Stanley: We expect the Fed to leave its interest rate target unchanged. The statement will likely indicate that the normalization of the central bank’s balance sheet will begin relatively soon, solidifying expectations for a September announcement. The Fed will also make a benign update on conditions, by saying that the economy continued to expand at a moderate pace and that the labor market is still strengthening; the Fed should also say that inflation is running below its 2% goal. Weak inflation data will continue to be a thorn in the Fed’s side for several months to come. The Fed will resume hiking rates in December.
  • Deutsche Bank: We do not expect the Fed to take any policy firming actions this week, partly because inflation has continued to surprise to the downside of late. In our view, policymakers will need to acknowledge the further decline in (PCE) inflation since the June meeting, but their medium-term view that inflation will return to target should remain unchanged. This would keep the door open for the Fed to begin its balance sheet normalization program as well as raise interest rates another 25 basis points by year-end. While it is possible that the Fed announces the former on Wednesday, we believe this holds a low probability. We continue to view the September meeting as the most likely timing for the Fed to announce the tapering of SOMA reinvestments, which would ostensibly begin in October.
  • Barclays: We expect the Fed to keep the target rate for the federal funds unchanged and expect few changes to the statement outside of balance sheet normalization. We believe the statement could point to an announcement on balance sheet policies at the September meeting. The risk to our view is that the FOMC announces its balance sheet normalization program at the July meeting since we believe the committee is eager to begin the process. That said, an announcement on balance sheet normalization in July would leave open the possibility of two additional rate hikes this year. This would likely send a more hawkish signal than warranted given the incoming data on activity and, in particular, inflation.
  • SocGen: We expect the Fed to announce the start of its balance sheet normalisation plan in September, but we acknowledge that it is a coin toss between this week’s meeting and the next one. In any case, we do expect a tweak in the paragraph on the balance sheet that should confirm the market’s expectation that the Fed will announce the shift in September.
  • HSBC: We expect the FOMC to leave the target range for the federal funds rate unchanged until December. We do not expect much change in the policy statement’s assessment of current economic conditions or the economic outlook. We expect the FOMC to say that it expects to begin implementing a balance sheet normalisation programme “relatively soon,” a change from the June policy statement that indicated the programme would begin “this year”. This would allow the Committee to formally announce the start of disinvestment in September, for commencement in October. However, there is also the possibility that the FOMC could simply announce the change in balance sheet policy at the July meeting, for commencement in October.
  • RBC: This should be one of the more boring Fed releases in a while. There should be only modest adjustments to the characterization of the economic backdrop and we expect no change to the policy language. We think the announcement regarding the start of the balance sheet run-off comes at the September meeting when we also believe the committee will stand pat on rates (we expect the next hike in December).

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