The Fed Makes another Historic Move

The markets are hoping and expecting that the Fed’s next moves will be boring.

Investment markets largely were controlled by central banks from the time the Fed began its “extraordinary measures” in 2009 until it ended quantitative easing in 2014. In quantitative easing, the Fed purchased securities in the open market to inject cash into the economy. It stopped buying new securities in 2014 as the first step in returning to normal monetary policy.

The next step, which the Fed announced will begin in October, is to let the bonds and mortgages on its balance sheet “run-off” or “roll-off.” That means the Fed won’t reinvest the proceeds from maturing securities.

Though the Fed stopped adding to its balance sheet in 2014, it didn’t reduce the amount of securities it owns. As securities mature, the issuers pay the principal to the Fed. So far, the Fed’s been reinvesting that principal by purchasing new bonds and mortgages. So, the amount of assets held by the Fed hasn’t changed. It owns about $1.7 trillion in mortgage securities (about 29% of the market) and about $2.4 trillion in U.S. Treasury securities (about 17% of the market).

Now, the Fed plans to let the balance sheet run off by not reinvesting the proceeds of maturing securities. That’s considered a tightening of monetary policy, since money is coming out of the markets and economy.

The Fed’s planning to start the run-off slowly and gradually, as with its other measures, and to stop if the economy falters. The current plan is to shrink the balance sheet by about $10 billion of securities per month and to increase that by $10 billion quarterly to a maximum of $50 billion by next October. The Fed will continue to buy bonds each month, because the amount of securities maturing will be much greater than the amount by which it plans to shrink the balance sheet.

Still unanswered is the question of how much the Fed ultimately will allow its balance sheet to shrink. Before 2008, it had less than $900 billion in assets. Today it has about $4.5 trillion in holdings. Does the Fed eventually plan to return to the pre-2008 level, perhaps adjusted for the size of the economy? Or will it stop the run-off sometime before that? How long will the run-off take? The Fed has set goals only for the next 12 months. Of course, investors assume the Fed will cease the run-off if the economy slows considerably.

Significant personnel changes at the Fed also increase uncertainty. Three of the seven seats on the board of governors are vacant. Fed Chair Janet Yellen’s term expires in February, and Vice Chairman Stanley Fischer has announced he’s leaving the Fed soon. There’s no indication yet as to who will fill these positions.

The Fed and other central bankers need to keep in mind that they have few tools to stimulate the economy if it should falter. Interest rates still are very low. Each new phase of quantitative easing had a weaker effect than the previous one. That’s why one of the biggest risks to the economy is the Fed might tighten too much.

The Data

The hurricanes are starting to affect economic data.

Retail sales were down 0.2% in the headline number, but lower auto sales were a big part of that. Excluding autos, retail sales increased 0.2%. That’s still a weak number. Also, last month’s 0.6% increase was revised down to a 0.3% increase.

Industrial Production declined 0.9%, and the manufacturing sector declined 0.3%. Though the hurricanes had some effect, the report continues the puzzle of hard economic data being much weaker than the surveys and anecdotal reports.

For example, the Empire State Manufacturing Survey continues to be very strong. It was reported as 24.4, down only a little from last month’s 25.2. Some analysts described this report as “overly strong” and needing to decline to avoid overheating.

The Philadelphia Fed Business Outlook Survey rose sharply to 23.8 from 18.9. This survey has been the strongest among the anecdotal surveys. The only weakness was in employment growth.

Leading Economic Indicators from The Conference Board increased another 0.4%, indicating growth is likely for the next six months. Nine of the 10 components of the index were positive.

Consumer Sentiment, as measured by the University of Michigan, was 95.3, down a bit from 96.8. But it’s still a strong report, with the current conditions measure at the highest level in almost 17 years.

Optimism among home builders continues its modest decline from the highs of late 2016 and early 2017. The NAHB Housing Market Index fell to 64 from 67. That ties for the weakest month of 2017. A lack of first-time buyers continues to affect the index.

Yet housing starts increased and were more than expected. Also, last month’s starts were revised a little higher. Likewise, permits issued increased more than expected. The starts were higher nationally despite a drop in the South due to the hurricanes.

Housing price increases continue to moderate. Prices rose 0.2% in the last month and 6.3% over 12 months, according to the FHFA House Price Index. That’s still a hefty gain over 12 months that exceeds income growth.

New unemployment claims declined by another 23,000. Analysts were expecting an increase due to the hurricanes and now speculate that the hurricane disruptions were so severe that people haven’t been able to file claims.

The Markets

The S&P 500 returned 0.44% for the week ended with Wednesday’s close. The Dow Jones Industrial Average surged 1.18%. The Russell 2000 rose 1.34%. The All-Country World Index added 0.72%. Emerging market equities gained 1.17%.

Long-term treasuries declined 0.55% for the week. Investment-grade bonds rose 0.09%. Treasury Inflation-Protected Securities (TIPS) fell 0.40%. High-yield bonds returned 0.28%.

The dollar lost 0.08%.

Energy-based commodities gained 1.57% for the week. Broader-based commodities rose 0.07%. Gold fell 1.25%.

Bob’s News & Updates

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