Fed set to raise rates, focus turns to balance sheet and inflation outlook

With a rate rise at the conclusion of the Federal Reserve’s two-day policy meeting on Wednesday a near certainty on Wall Street, the focus now for investors is when the central bank will begin trimming its balance sheet amid a mixed backdrop of low inflation and continued labor-market strength.

Economic data since the Fed’s March meeting, when it opted to lift rates by a quarter percentage point, has shown the nation’s unemployment rate falling four percentage points as the so-called slack in the labor market diminishes. However, inflation as measured by the central bank’s preferred gauge, the core personal consumption expenditures index (which strips out volatile food and energy components) had dipped two percentage points on a year-over-year basis to 1.5%, well below the 2% target.

“We don’t think the recent data call for a major change in the Fed’s policy outlook,” economists at Goldman Sachs Economic Research said, pointing to speeches from central bank policymakers over the past several weeks that emphasize the need for a patient and balanced approach to changes in monetary policy.

The CME Group’s closely-watched federal funds futures, which measure market expectations for changes in monetary policy, show odds for a rate increase to between 1% and 1.25% this month at 95.8%.

Another complicating factor for the Fed is the divergence between equity prices that, despite a pullback in the technology sector the last two sessions, continue to trade near record levels, and a bond market that could be signaling caution ahead. Bond yields, which move inversely to prices, have come down from post-election highs. What’s more, the yield curve has flattened as the federal funds rate and other shorter-term duration bond yields move higher while longer-term yields have been relatively unmoved.

“As long as inflation remains soft – or gets softer still – and the potential of pro-growth fiscal policy remains but a figment of the imagination, not to mention an increasingly contentious world amid ongoing geo-political risk, interest rates on the longer end of the curve will continue to compress,” said Lindsey Piegza, chief economist at Stifel.

Investors should get more clarity on the Fed’s thinking when it releases its Summary of Economic Projections alongside its policy decision Wednesday afternoon at 2:00 p.m. ET. Goldman Sachs economists expect policymakers to lower both their GDP growth expectations for 2017 and their unemployment rate forecast to 4.3% this year and 4.2% in 2018 while the hunt for 2% inflation remains elusive until at least 2019.

Fed officials have signaled at least two more rate hikes before the end of the year, but some on Wall Street have pondered the possibility of balance-sheet normalization – the process of reducing the central bank’s $4.5 trillion in Treasuries and mortgage-backed securities – as the next phase in the tightening cycle.

“We expect balance sheet adjustment to start in September and the Fed hiking cycle to resume in December. With respect to the balance sheet, we assume initial caps on the amounts of securities that can run off in any given month of $10 billion for U.S. Treasuries and $5 billion for mortgage-backed securities, that rise over four quarters to caps of $40 billion and $20 billion, respectively,” the Goldman economists estimate.

At the end of May, Fed officials said as long as the economy’s growth momentum was sustained, they planned to continue normalizing policy and trimming the balance sheet. Until this point, the Fed has maintained its balance sheet by reinvesting principle when older bonds mature. Much of those assets were a product of a monthly bond-buying program enacted in the wake of the 2008 financial crisis, aimed at jump starting the economic recovery.