Economic Update


The Fed to Taper Its Balance Sheet

U.S. Fed Chairman Janet Yellen announced after the Federal Open Market Committee (FOMC) meeting that the benchmark interest rate target range would be lifted a notch to 1-1.25%, effective 15 June. The interest rate hike was the second in 2017, and the third in six months. In addition to the much anticipated rate hike, the post-FOMC meeting announcement also shed light on what to expect in the future.

Sustained labour market momentum supported the rate hike

We have taken note of the Fed’s reasoning behind the rate hike being the sustained labour market performance, but there are some alternate views that the U.S. labour market is losing steam. While many of these latter claims point to the slowing non-farm payroll growth (Chart 1) – which only saw an average gain of 120,667 jobs in the three months up to May 2017, the slowest increment since July 2012 – the decline is well anticipated. As we have pointed out many times, a much higher comparable base from the continuous employment expansion over the last few years would lead to smaller new job creation this year, so we do not consider this moderation a negative surprise.

Indeed, we argue that the labour market has gained further momentum in the last few months. The unemployment rate – one of the two key metrics that the Fed monitors – has fallen to 4.3% in May, the lowest level since May 2001 (Chart 2). At the same time, jobs are plentiful, with the job openings rate remaining high at 4% as of April 2017.[1] Given these trends, we maintain our view that the U.S. labour market is dynamic and should support the economy in the near term.

The Fed’s effort to taper its balance sheet

Projections by the Fed officials showed optimism in the economy. Compared to the projection in March, the officials expected improvements in GDP and the unemployment rate in the June meeting (Table 1). In light of a stable economic environment, the median projections of the Fed funds rate for 2017 and 2018 have remained at 1.4% and 2.1% respectively. Such projections implied that there would likely be one additional rate hike in 2017 and three in 2018.

Due to these improved economic projections, on top of lifting the Fed funds rate, the Fed announced that “all [FOMC] participants agreed to augment the Committee's Policy Normalization Principles and Plans.”[2] The announcement indicated that the Fed would reduce its securities holdings by cutting back its reinvestment of the principal payments from both the Treasury securities and agency debt and mortgage-backed securities. In the release, the Fed set an initial cap in the reduction of reinvestment at US$10 billion per month, but the limit would steadily increase by US$10 billion every quarter and eventually reach US$50 billion per month in a year’s time.


The above Fed actions and projections show that the Fed has become more convinced that the economy is gathering momentum. We also observe that, despite the potential shocks resulting from the recent U.K. election and political events in the Middle East, the FOMC has removed its emphasis on “external uncertainties” in the announcement, which should be viewed as a hawkish statement.

Given the continuous improvement in the labour market conditions and the consequential hawkish rhetoric of the Fed, we maintain our view that there will be one more rate hike by the end of 2017. However, since the Fed would be “monitoring inflation developments closely,” and we do not expect inflation to rise significantly in the near term due to the low crude prices, the next rate hike would likely not happen until the FOMC meets in December.

As for the tapering, we believe the plan may not be conclusive. As the actual impact of the Fed’s decision to taper its balance sheet is uncertain, the underlying demand for reserves cannot be accurately estimated at this juncture. Therefore, if the tapering will lead to major setbacks to the economy, chances of the Fed making adjustments to the Normalization Principles and Plans should by no means be ruled out.

[1] The job openings rate is the number of job openings on the last business day of the month as a percentage of total employment plus job openings

[2] FOMC issues addendum to the Policy Normalization Principles and Plans


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