Fed: Weighing the options in its toolkit heading into H2 – Wells Fargo

The analysis team at Wells Fargo Securities have adjusted their outlook for the timing of the FOMC’s next rate hike and balance sheet reductions as they now believe the next fed funds increase will occur in December rather than September.

Key Quotes

“At the September meeting, we expect the Fed to refrain from raising rates as it officially announces its balance sheet reduction program, which in our view will begin a few weeks later at the start of Q4.”

“Softer inflation is the key driver of our view that the FOMC will proceed with caution when tightening policy over the next few months. Core inflation, as measured by the PCE deflator, has drifted lower every month in 2017 on a year-ago basis and reached its lowest level since December 2015 in last Friday’s release. Further, the three-month annualized rate for the core PCE deflator has fallen to near zero, suggesting little upward momentum in the short-term.”

“In some ways, the dip in core inflation has reflected one-off factors. Wireless telephone services have weighed on inflation due to a methodology change in the government’s calculation and cutthroat competition among the major providers. The slowdown has been broadening, however, with decelerations seen in some sectors that have driven core inflation in recent years, such as shelter and medical care. With oil prices likely to weigh on the headline in the short-term, the dual tightening of balance sheet normalization and a fed funds increase in September seems like a bridge too far for Chair Yellen’s cautious style.”

“The Fed has stated that the fed funds rate will remain the primary tool for setting monetary policy, while the balance sheet program will be a secondary tool designed to run in the background. Thus, initiating balance sheet reductions in September while holding off on a hike buys the Fed more time to see how the inflation and economic growth data play out over the second half of the year before resuming its preferred form of tightening. Beginning the balance sheet wind down sooner rather than later would also help cement the program in replace before Chair Yellen’s term ends.”

“We still anticipate one more rate hike before the year is out. The labor market continues to exhibit strength, and in our view economic growth should improve in Q2 and the second half of this year relative to the slow pace of growth in Q1. These dynamics should presage a turnaround in core inflation as the year progresses. Encouragingly for the Fed, market-based inflation expectations have shown some signs of a rebound after sliding for the past several months. If this policy path is realized, Chair Yellen would potentially exit her post early next year with the legacy of having finally lifted short-term rates off the zero-bound while also initiating the first balance sheet reductions after nearly a decade of outsized Fed holdings.”