On Wednesday, the Federal Open Market Committee left US interest rates unchanged, in line with market expectations. The FOMC statement noted slower growth in household spending and business investment, but there was no change to the remaining text, including this key phrase: "the Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate."
There were, however, two significant developments from the meeting:
- First, the updated "dot plot," which indicates where FOMC participants expect rates to be at the end of each calendar year, showed a significant downgrade. The December dot plot indicated two rate hikes by the end of 2019, while the new dot plot has no hikes in 2019. This was not a huge surprise given that recent economic data has been weak, but going into the meeting we were expecting the dots to show one hike in 2019.
- Second, the FOMC announced a new plan to adjust the Federal Reserve's balance sheet. The cap on Treasuries will be lowered to USD 20 billion a month from May, and zero after September. The cap on mortgage-backed securities (MBS) will remain at USD 20 billion a month, but from October maturing MBS will be replaced with Treasuries. As a result, after September the Fed's total securities holdings should stabilize. This will leave the size of the Fed balance sheet at around USD 3.7 trillion, down from a peak of USD 4.5 trillion, but still much larger than pre-financial-crisis size of less than USD 1 trillion. While the crisis is over, the balance sheet will remain larger because the Fed has changed the way it conducts monetary policy and will leave excess reserves in the system.Market reaction was significant, with the dollar falling by around 0.6% against other major currencies, and 2-year Treasury yields down 8 basis points from Tuesday's closing level. The market is now fully pricing in a 25-basis-point rate cut by the middle of 2020. As Fed Chair Jay Powell stated in his press conference, current data does not point to a rate move in either direction.
In our view, US economic growth should be around 2% in both 2019 and 2020, with the unemployment rate remaining low and core inflation near the Fed's 2% target. Under these circumstances, there would be no reason for the Fed to move rates in either direction.