FED – “SHRINKING” TO BEGIN NEXT MONTH; NO RATE HIKE THIS MONTH

By Ruma Dubey

The Federal Reserve did not disappoint. As was widely anticipated, apart from no hike in rates this time, the vote was for beginning the portfolio reduction from October. The vote was also for keeping the interest rate in the range of 1 to 1 to 1.25%, which in turn means that we are looking at a rate hike in December.  And it has signaled three more rate hikes in 2018 and two in 2019.

Going into the details of the balance sheet reduction, the Fed said that that tapering off of mortgage-backed securities would begin Oct. 13 and the process of shrinking their portfolio of Treasury securities would begin with Treasuries maturing Oct. 31. Though a detailed map was not given, the Fed only stated that it will allow $10 billion to roll off at first, increasing quarterly in $10 billion increments until the total hits $50 billion starting in October 2018.

There was no word on the existing financial conditions, whether there has been any impact whatsoever after the previous rate hikes. It only went on to say that the Fed will look into the financial factors as they contemplate what to do with interest rate increases.

When we say, “shrinking of the balance sheet” what it means that the Fed, from October will begin the process of unwinding the $4.5 trillion of bonds which is holds on its balance sheet. These bonds were piled up in the aftermath of the 2008 Wall Street collapse or what was then known as “Quantitative easing” or “QE;” in simple terms, it meant the amount of money it printed to keep recession at bay.

Out of this $4.5 trillion, $3.7 trillion was from the three rounds of buying or QE. This apart, the Fed also purchased Treasurys totaling $2.46 trillion and mortgage-backed securities valued today at $1.77 trillion.

So when we talk about “shrinking” the question is what the Fed will do with the bonds – allow it to mature and not reinvest or sell them before maturity. Naturally, the Fed is opting for the former one.  Point to be noted here – inflation will go up once balance sheet shrinking process begins and the Fed itself has already begun that process.

The FOMC statement does not spell out the size of the balance sheet once the shrinking process is completed – it is sure to be bigger than what it started with in 2008 but by how much, no details on that.

The message that comes across is that the Fed is not going to be aggressive when it comes to interest rate hikes as well as downsizing its balance sheet. Thus one need not fear any major disruptions.

For the Indian markets – it will be business as usual; it was on ‘hold’ for the past two days as all wanted to get over with this FOMC meet. Now that it is done, it will be back to some saddle-less ride upwards until we start holding back again for the RBI meet on 4th October.