Fed Resists the Doves

The big news today wasn't the Federal Reserve's decision to start gradually reducing its balance sheet in October. Almost everyone expected that. Instead, the big news was that twelve of the sixteen members of the Fed's interest-rate setting body – the Federal Open Market Committee – think the Fed will be raising interest rates by at least 25 basis points later this year.

As recently as two weeks ago, the futures market in federal funds was generating about a 20% chance of another rate hike this year. Earlier today, before the Fed's statement, the odds were roughly 50%. Now the odds are in the 60-65% range. We think those odds are likely to rise even further in the months leading up to the December meeting.

In the meantime, the Fed will be reducing its balance sheet at a pace of up to $10 billion per month for the fourth quarter, increasing that to $20 billion monthly pace in the first quarter of 2018, $30 billion in Q2, $40 billion in Q3, and $50 billion in Q4. After that, the Fed is projecting it would maintain that $50 billion monthly pace until it's satisfied with the size of the balance sheet. This is no different than what the Fed said it would do three months ago at the meeting in June. (For the foreseeable future, the balance sheet cuts would be 60% in Treasury securities and 40% in mortgage-related securities.)

The Fed made some other changes to its "dot plot," but not in the near-term. The dot plot still suggests three rate hikes in 2018. However, back in June the median Fed path suggested three rate hikes in 2019, maybe four; now the Fed is torn between two or three rate hikes in 2019. In addition, back in June the median Fed path suggested a long-term average funds rate of 3.00%; now it's 2.75%.

In terms of the Fed's economic outlook, there were barely any changes. The Fed expects a little more real economic growth this year and a little less inflation, leaving nominal GDP growth (real GDP growth plus inflation) unchanged. The Fed's statement was a little more bullish on business investment and made it clear it wasn't worried about the medium-term economic effects of Hurricanes Harvey and Irma.

Notably, there were no dissents from today's statement, not even Minneapolis President Neel Kashkari, who made a dovish dissent two meetings ago back in June.

Although some may still fear the effects of the Fed renormalizing its balance sheet, we think the Fed should have started this process a long time ago and could even speed it up faster without hurting the economy. Could long-term interest rates go up? Sure they could! But they should have been higher already given economic fundamentals. While others fret about renormalization and rising rates damaging the economy or financial markets, investors should remain bullish. Look for faster economic growth and a continuation of the bull market in equities in the years ahead.

This information contains forward-looking statements about various economic trends and strategies. You are cautioned that such forward-looking statements are subject to significant business, economic and competitive uncertainties and actual results could be materially different. There are no guarantees associated with any forecast and the opinions stated here are subject to change at any time and are the opinion of the individual strategist. Data comes from the following sources: Census Bureau, Bureau of Labor Statistics, Bureau of Economic Analysis, the Federal Reserve Board, and Haver Analytics. Data is taken from sources generally believed to be reliable but no guarantee is given to its accuracy.

© First Trust Advisors

© First Trust Advisors

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