US FOMC: Let the great adjustment begin - BNP Paribas

"The FOMC initiated its well-telegraphed balance sheet adjustment in line with its “Policy Normalization Principles and Plans,” which were introduced at its June meeting. The shift came as no surprise, and expectations for one more rate hike in 2017 and three in 2018 were unchanged from their June meeting," Paul Mortimer Lee, Chief Market Economist and Head of US Economics at BNP Paribas, wrote.

Key quotes:

"Overall, the Committee’s economic forecasts changed very little, with a mildly lower unemployment rate in 2018 and core PCE inflation marked-to-market for 2017 – supporting what many on the FOMC have described as transitory price effects"

"Now with the balance sheet adjustment underway, the Fed will assess the impact of the shift and closely monitor inflation developments in the coming months before deciding on the next move. In our view, data are likely to be disrupted by the hurricanes, and the uncertainties surrounding the inflation outlook are unlikely to be resolved before the December meeting. Nevertheless, the Committee is sending a fairly strong signal that they could look through the data disruptions as the majority continue to expect one more hike this year. We feel nervous about our forecast for the Fed to remain on hold until March 2018, and will be closely monitoring incoming data."

"Balance sheet policy"

• The balance sheet “normalization” will begin in October with the caps on the run-offs in Treasuries and agencies initially set at USD 6bn and USD 4bn per month, respectively.
• The caps are expected to increase by USD 6bn for Treasuries and USD 4bn in agencies every three months until they reach a limit of USD 30bn and USD 20bn, respectively.
• The caps will remain in place until the Committee thinks the balance sheet is at an equilibrium level – we see this as about USD 3.0-3.5trn, with some on the FOMC board suggesting it will take about four years to reach."

"Economy"

• Generally, the adjustments to the language about the economy were positive with upgrades to job gains, household spending and business investment.
• There was a carve-out in the statement to acknowledge the potential disruptions from Hurricanes Harvey, Irma and Maria, which were “unlikely to materially alter the course of the national economy over the medium term.”
• The adjustments to the Summary of Economic Projections were modest, with a slight reduction in the unemployment rate in 2018 and 2019, lower near-term inflation and slightly better GDP growth in both 2017 and 2019.
• The median estimate for longer-run GDP, the unemployment rate and inflation were all unchanged. 

"Rates"

• The dot plot of appropriate interest rates revealed a broad drop in expected rates, including the long-run  neutral rate that declined to 2.8% from 3.0%. 
• For 2017 and 2018, while the median dot did not fall, the hawks dropped their expectations a bit, as they did for 2019, when we believe the median rate will decline 25bp.
• With the difficulty to parse out the trend in data on the back of the hurricane impacts, we think there is a good case for the FOMC keeping rates on hold for the remainder of the year.
• The September statement has left the door for a December rate hike very open. Like the Fed, we will be monitoring the inflation data in the coming months.
• The risk is that the Fed looks through the data disruptions and with prices rising as a result of the hurricane disruptions, they deliver another 25bp rate hike at the end of the year.