The Federal Open Market Committee (FOMC) last week decided to raise its target federal funds rate again, to between 1% and 1.25%. The move was anticipated by markets and moves the target rate above 1% for the first time since 2008. The Fed also publicized for the first time the method it intends to use to shrink its balance sheet in the future.
Interest Rates Continuing to Rise
The Fed’s raising of the target federal funds rate is the second rate hike this year. Each of the rate hikes has come at an FOMC meeting that has been followed by a press conference by Chairman Janet Yellen. Despite Yellen’s prior insistence that rate hikes could occur at FOMC meetings that aren’t followed by a press conference, that hasn’t been the pattern. That is perhaps understandable, since the press conferences allow Yellen to explain to the media the reasoning behind raising rates. The FOMC likely fears that raising rates at meetings that aren’t followed by a press conference would lead to confusion in financial markets.
If we expect the same pattern to continue, then there should be two more rate hikes this year, after the September 19-20 meeting and after the December 12-13 meeting. That would leave the federal funds rate at 1.5-1.75% at the end of the year.
Balance Sheet Normalization to Begin This Year
The FOMC expects to begin drawing down the Fed’s large balance sheet once “normalization of the level of the federal funds rate is well under way.” What the FOMC sees as normal is anyone’s guess, but there is speculation that it could begin as early as July. In the FOMC statement, the Fed announced that the draw-down process would begin this year. The Fed’s balance sheet currently sits at around $4.5 trillion, with nearly $2.5 trillion of Treasury securities and $1.8 trillion of mortgage-backed securities making up the bulk of the Fed’s assets.
The Fed has maintained a policy for years of reinvesting principal payments from its holdings of Treasury securities, agency debt, and mortgage-backed securities. Once the normalization process starts, the Fed expects to reinvest securities that exceed a cap that it will set, one which will rise gradually over time.
Breaking it down, the Fed expects that it will draw down its holdings of Treasury securities by at most $6 billion per month for the first three months of normalization, then $12 billion per month for the next three months, then $18 billion per month for three months, $24 billion per month for three more months, and then $30 billion per month after that. For its agency debt and mortgage-backed securities, those figures are $4 billion, $8 billion, $12 billion, $16 billion, and $20 billion respectively.
So that means that the Fed expects to decrease its balance sheet by at most $10 billion per month for three months, $20 billion per month for the next three months, $30 billion per month for three more months, $40 billion per month for the next three months, and $50 billion per month after that. That would mean a balance sheet reduction in the first year of at most $300 billion, or just under 7% of the current balance sheet. Cutting the Fed’s balance sheet in half would take over four years, and even then the balance sheet would be more than double what it was before the financial crisis. The FOMC also has not indicated what level it seeks to target for its balance sheet in the future, only stating that the balance sheet will be larger than it was pre-crisis.
At any rate, this means that full policy normalization probably won’t take place before 2020. And because the Fed left so much leeway in its statement to resume principal reinvestments or enlarge the balance sheet should it feel necessary, it could be even longer before policy is normalized.
Given that the Fed’s loose monetary policy up to now has fueled the bubble in stocks and bonds, that bubble will eventually burst. We will see a repeat of 2008, or perhaps an even larger financial crisis. That will mean an increase in demand for gold and an increase in price. Investors who see the crash coming and invest in gold now will reap the benefits in the future.