FOMC Review Snapshot

• The FOMC kept the federal funds rate target range at 1.00-1.25%, as expected.
• Inflation remains below the Fed’s 2% target and is slowing, leading the Fed to pause after June’s rate hike.
• The FOMC stated it plans to implement its balance sheet normalization program relatively soon.

Details

The Federal Reserve’s Federal Open Market Committee (FOMC) held the federal funds rate target range at 1.00-1.25%. The Fed sets monetary policy to satisfy its dual mandate to maximize employment and maintain price stability.

The fed funds rate remains unusually low and its significance as a monetary policy tool is reduced by the interest the Fed pays on bank reserves,[1] particularly interest on excess reserves (IOER), currently at 1.25%. Banks used to hold few excess reserves, choosing instead to lend these funds. If banks wanted more funds they would borrow from other banks at the fed funds rate. Since 2008, however, the Fed has been paying IOER and banks have been holding substantial excess reserves, currently about $2 trillion (55% of the monetary base.[2] The monetary base (part of the Fed’s balance sheet) is enlarged at $3.8 trillion. Before the last recession began in December 2007, it was $0.8 trillion (Fig. 1).

The actual (and expected[3]) inflation rate continued to decrease in recent months, and remains below the Fed’s 2% inflation target (Fig. 3). The unemployment rate (Fig. 2) has fallen to lows not seen since 2001. Normally, this implies the economy is near full employment. However, persistently below-target inflation and a low employment-to-population ratio suggest the American economy still has significant untapped growth potential.

Context

The FOMC decided to hold its interest rate target range constant and stated its balance sheet normalization program would begin relatively soon, although it did not give a specific date. The fed funds futures market is not anticipating another interest rate hike until at least January 2018. The slowing inflation rate, which has persistently been below the Fed’s 2% target rate since 2012, is the key variable to watch.

The Federal Open Market Committee (FOMC)

The FOMC meets 8 times per year. It consists of the 7 governors from the Fed’s Board of Governors in DC (3 seats are currently vacant), and 12 regional Fed bank presidents.

While all Fed governors have a vote on the FOMC, only 5 Fed bank presidents can vote. The NY Fed president is a permanent voting member, and 4 others can vote on a rotating basis.

Minutes of the FOMC meeting are released three weeks later.

Figure 4 shows JEC’s projection of Fed-held Treasuries and MBS. These account for 95% of the Fed’s $4.5 trillion balance sheet. Assuming normalization begins in October 2017 and the runoff caps are always binding, the balance sheet will shrink from $4.5 trillion to $2.7 trillion by the end of 2020.

However, this might occur more slowly than shown in Figure 4 as the runoff caps may not always bind. 99% of Fed-held MBS have maturities of 10 years or more. The pace of the MBS runoff the next few years will depend on the rate at which people refinance their mortgages and pay them off early. Hence, it is not clear whether the MBS runoff caps will be met. It is more likely that the runoff of the Fed’s Treasury holdings will consistently meet the caps, because Treasuries have definite payoff dates and 60% mature within 5 years.

Before 2008, over 50% had maturities of 1 year or less, but now less than 10% do. The Fed has stated that it plans to return to using Treasuries exclusively to execute monetary policy rather than also using MBS. However, it has not clarified whether it will return to the pre-2008 maturity distribution.

Lastly, the Fed has not specified what it intends the steady-state size of its balance sheet to be, or how long it will take to get there.