The Fed is expected to hold interest rates steady Wednesday, but this week’s meeting could be livelier than it seems because of the hot debate within the Fed about when it will reach the natural end point of its rate hiking cycle.
That discussion is likely to be a focus at the Fed’s meeting and could come to light in the release of meeting minutes later in August. Some Fed watchers say the Fed is nearing a point where it may suggest it’s getting close to neutral for fed funds, or the level where interest rates neither speed up nor slow down the economy.
Many Fed watchers do not expect the Fed to acknowledge any changes publicly Wednesday, but it is definitely expected to be part of the closed door discussion.
“We have virtually a 95 percent chance we have a rate hike in September, and the Fed will signal that and be very clear they have a tailwind in growth and a warming trend in inflation. They’re where they want to be,” said Diane Swonk, chief economist at Grant Thornton. She said Fed officials are unlikely to reveal anything new on when they could see an end to their rate hiking policy, and one wild card they have to consider is whether trade conflicts will ultimately hurt the economy.
“It certainly is a possibility that there is not complete consensus on what is the tipping point between the accommodation and tightening policy. There are many members including [New York Fed President] John Williams who believe that when they hit the fourth hike this year, they’ll be moving into neutral territory,” she said.
The Fed said in the minutes from its June meeting that it could reach neutral “sometime next year.” The Fed also said in those minutes that it could ultimately alter the language in its statement that says “the stance of monetary policy remains accommodative.”
“If they did that, that [now it] would be a market mover. The curve would probably steepen on that, and the stock market would go up a lot,” said Jim Caron, fixed income portfolio manager at Morgan Stanley Investment Management. Caron said such a move would be construed as dovish, and he doesn’t see the Fed moving away from that language for now.
He expects the neutral rate to be reached when the Fed rate hikes reach the 3 percent level next year, after another four hikes. It is now holding fed funds futures between 1.75 and 2.00 percent,
The Fed’s discussions Tuesday and Wednesday also come against a backdrop of debate in the markets, where there continues to be disagreement over how many more rate hikes the Fed will be able to carry through.
Some economists doubt the Fed will be able to hike the two more times it has forecast for this year because of the flattening of the yield curve, or the narrowing of the gap between short term Treasury yields and longer term yields, a potential sign of economic trouble.
“I think the debate is out there which is why removing ‘accommodative’ wouldn’t be that crazy,” said Tom Simons, money market economist at Jefferies. Simons said the Fed actually could suggest it’s moving closer to the end of its rate hike cycle Wednesday, not by removing the language about being accommodative, but by adding the words “for now.”
Mark Cabana, head of U.S. short rate strategy at Bank of America Merrill Lynch said he does not expect the Fed to change the language until it hikes rates again in September at the soonest. He said another topic up for discussion this week but not likely to be mentioned in the statement is what the Fed intends to do with its balance sheet, which it has gradually been shrinking.
Fed Chair Jerome Powell mentioned the balance sheet during recent congressional testimony. “Powell’s language around that suggests it’s being teed up for discussion here,” Cabana said. “He said they’re going to be returning to their monetary policy framework discussion in a serious way in the relatively near future.”
Cabana said the Fed could mention the balance sheet in its minutes, to be released Aug. 22, and that could also be a focus at its annual Jackson Hole, Wyo. symposium on Aug. 23. The Fed is intentionally shrinking its balance sheet, inflated by quantitative easing bond purchases, by allowing maturing securities to roll off its balance sheet without replacing them.
“The subject of that symposium is changing market structure and implications for monetary policy,” Cabana said. He said the Fed could send a message to markets from its Jackson Hole meeting.
“Powell’s talking about the framework…that leads me to believe they’re going to be shifting focus on this, especially since they raised rates they only increased the interest rate on reserves by 20 basis points, instead to 25 basis points,” he said.
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