Following this week's meeting of the Federal Open Market Committee (FOMC), the Fed issued a statement that more forcefully signaled its intention to be cautious in the face of a more uncertain outlook. Policymakers also signaled that they view the current stance of monetary policy as more or less neutral. Therefore, investors should expect the Fed to keep rates steady, for now.
We think the Fed is right to be cautious in the face of rising global economic risks along with uncertainties surrounding politics and policy. Amid only modest inflationary pressures and financial imbalances, a cautious approach is consistent with a balanced risk management strategy that should ultimately lengthen the economic cycle.
Consistent with this, markets have taken note of the Fed's shift toward caution, and financial conditions have eased again after the significant tightening in late December. The decline in interest rates and recovery in equity prices should help assuage the risk that the U.S. economy slows more meaningfully in 2019.
Balance sheet as a policy tool
Further softening its tone, the Fed also reiterated that during a downturn, it would be prepared to use its full range of tools - including altering the size and composition of its balance sheet (e.g., via substantially more asset purchases or "quantitative easing") - if a more accommodative monetary policy could not be achieved solely by reducing the Fed Funds rate.
Fed officials also confirmed that they will maintain the current floor system for setting monetary policy, in which the Fed relies on its administered rates to control a broader range of money market rates. This suggests that the process of shrinking the balance sheet could conclude by the end of 2019.
Importantly, Chairman Powell in his press conference did not clarify whether and how the Fed plans to continue to normalize the composition of the balance sheet when the amount of financial system reserves reaches its steady-state level. Recently, policymakers have discussed various ways of shortening the duration and returning to an all-Treasury portfolio. However, in the end, we suspect the Fed will also seek to maintain a neutral stance on its balance sheet by reinvesting the maturing proceeds pro rata across Treasury auctions.
Implications for the near-term policy path
Looking forward, we believe Fed officials will again revise lower their views on the appropriate path of monetary policy when they release an updated Summary of Economic Projections in March. With the effective Fed Funds rate now only slightly below the Fed's range of estimates for neutral monetary policy (2.5-3.5%) - and, we note, already within PIMCO's New Neutral range (2-3%) - along with an outlook for overall financial stability and modest inflation in the U.S., we believe there is little reason to rush into more policy tightening.
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