Today the FOMC obtained an unusual objective: It completely walked back a policy narrative implemented in December without meaningfully changing its domestic economic outlook, all while signaling no interest rate increases in the near term. This is a rare strategic retreat by the central bank, clearly driven by doves on the committee. They have now elevated the drawdown of the balance sheet as a major policy focus, even as the federal funds rate remains the primary policy tool. In our estimation, this will require more transparency on the economic impact of the drawdown.
It will be necessary for the Fed in its rhetoric to attach estimates of what that drawdown means: for instance, a reduction of the balance sheet by $50 billion per month is equal to a rate increase of 1 basis point. Moreover, it would be useful to state that the FOMC expects the balance sheet to shrink by $500 billion to a size of $3.5 trillion, in contrast to the roughly $800 billion average prior to the 2007-2009 Great Recession. Anything short of that will result in important market participants coming to their own conclusions, which will not bode well for the direction of rates at the long end of the yield curve and stability across money markets.
In the post statement, press conference Fed Chair Jerome Powel chose not to provide further clarity on the optimal size of the balance sheet nor to comment concretely on its composition. This will need to be addressed sooner rather than later.
The policy paragraph contained significant changes that imply the Fed will be on hold at least for the first half of the year and perhaps longer. The FOMC inserted the word “patient” into its statement and removed language that stated “the committee judges that some further gradual increases in the target range for the federal funds rate will be consistent with sustained expansion.” Both of these changes have cemented an accommodative stance by a Fed that now states the economic outlook is solid, as opposed to strong in December. In addition, and the FOMC stripped its view of the balance of risks from its statement.
The result of these changes should shift market expectations of the path of policy throughout the remainder of 2019. Most importantly, it builds a bridge for the Fed to fall back further on its policy normalization campaign should global risks mount of further policy driven-action out of Washington, D.C. that causes the domestic economy to slow going forward.