US reaction: Fed unmoved on rates, tapers QT

The Federal Reserve (Fed) left its key policy rates unchanged, the Fed Funds Rate (FFR) target range at 5.25-5.50% and the interest on excess reserves (IoER) rate at 5.40%. This was by unanimous decision and was fully expected by us and wider markets. In a meeting with no quarterly forecast update, there was little change to the Fed’s accompanying statement. It added that “In recent months, thee has been a lack of further progress toward the Committee’s 2% inflation objective”, echoing Fed Chair Powell’s recent comments from the IMF. The statement also shifted its description to say that the risks to the Fed’s employment and inflation goals “have moved”, compared with “are moving”, toward better balance, a statement that also suggests improvement is passed rather than ongoing. 

In a more technical shift, the Fed also fulfilled its promise to slow the pace of its quantitative tightening (QT) operation, something that it had promised to deliver “fairly soon” at the last meeting. The Fed today announced that starting on 1 June the Fed would slow the pace of Treasury maturities to a maximum of $25bn/month from $60bn. It also announced that it would leave MBS and agency debt maturities at $35bn/month, with any maturities in excess of that being reinvested in Treasuries, roughly matching the maturity composition of the outstanding Treasury holdings. Given current conditions, the latter move is unlikely to be material over the immediate timeframe. The move to slow the pace of Treasury maturities serves two purposes. First, it will slow the withdrawal of liquidity from the system, reducing the risk that the Fed withdraws too much liquidity, as in 2019. We do not believe that this is an immediate risk, but we acknowledge significant uncertainty around the genuine level of demand for reserves in the system and so a more cautious pace is not inappropriate. Second, as described by Dallas Fed President Logan, a slower pace of liquidity withdrawal is expected to lead to a more efficient distribution of reserve holdings across the commercial bank space – rather than concentrating in larger banks. This is hoped to allow a greater withdrawal of reserves over time. With this slightly earlier and slightly faster tapering of QT, our estimates suggest that the Fed should be able to continue with QT until well into next year, before then freezing the balance sheet for a period of time for the final conclusion. The market impact of this move is likely to be small, but at the margin is likely to contribute to a modest easing in final conditions.   

Fed Chair Powell’s press conference was measured and balanced in its approach. He stressed that risks “had come into better balance”, but that the “lack of further progress” on inflation would require restrictive policy to have more time to deliver such progress. This echoed his IMF comments. Pressed on this point, Powell said he would let the data decide how much more time was necessary, but that the policy debate was around holding restrictive policy for longer – not raising rates further, something he described as “unlikely”. However, Powell stated that he expected to see further progress on inflation this year, although was unsure it would be sufficient for a policy easing. He also suggested that the Fed would need to see more than 1 or 2 months of evidence to gain confidence. He added that the Fed might also have to conceivably ease policy if the labour market were to unexpectedly weaken – a view consistent with the Fed having a better balance of risk to its mandates. The Fed Chair also once again dismissed the fact that the timing of the election would have any impact on the Fed’s decision to cut rates. 

To our minds, today’s meeting marked a holding pattern for the Fed, not least in the absence of providing further forecasts. The Fed has clearly moved from March’s position where it forecast three cuts this year. It will now await the evolution of data to determine when cuts begin, but the Chair made clear that at this stage the Fed is not considering rate hikes. Stronger Q1 data (inflation, labour market and consumer) led us to delay the time we expect the first cut from the Fed until September from June. We now forecast two cuts this year (and maintain our expectation for three next). However, we recognize that even a September cut is finely balanced and depends upon our expectation for headline inflation to remain around 3.5% over the middle of this year (although with core and monthly increases softening) and some signs of consumer deceleration continuing and helping to soften economic growth below a non-inflationary rate, that we do believe will remain a little firmer than longer-term estimates of trend. 

Markets appeared to react with some relief to the Fed’s decision today – perhaps fearing something more hawkish than Powell’s measured tone. In the event, the chances of rates cuts this year were priced higher, a September cut rising to 65% from 50% and two cuts this year rising to near 30% from below 10%. Accordingly 2-year Treasury yields fell, dropping to 4.92%, but rising to 4.95%, down 6bps, by the end of the press conference. 10-year yields fell 6bps to rebound by 5bps back to 4.63% at the time of writing and the dollar fell by 0.25% against a basket of currencies, although was 0.5% lower initially. We suggest that at this stage markets have more to fear from the data than the Fed.