Fed policy in focus

Video:Data with Donovan | What’s the Fed’s next possible move? (3 mins)
Video: Top of Mind in APAC | The current bull market and risks to watch (5 mins)
Podcast: Signal over Noise | The open model AI ripple, on Apple and Spotify (6 mins)

The Federal Reserve is due to announce its interest rate decision on Wednesday, as the Federal Open Market Committee wraps up its two-day meeting. Current futures pricing indicates a 30% chance of a rate hike as uncertainty in the Middle East continues to fuel inflation fears.

We expect the US central bank to keep the target range of the fed funds rate steady at 3.50-3.75%. The latest inflation data showed consecutive declines in core goods prices, and core services prices fell for the first time since 2020. The labor market also showed no signs of overheating, with real labor income growth consistent with a continued slowdown in consumer spending growth.

But several changes at the Fed may be coming, as Chair Kevin Warsh aims to have his five “Task Forces for Advancing Monetary Policy” complete their reviews by year-end. Any recommendations will ultimately require the backing of at least six other members of the 12-person Committee.

The communications and balance-sheet reviews are likely to be the most consequential, in our view, potentially affecting rates market volatility as well as longer-term bond market valuations. We discuss the likely changes and their implications.

The communications review has the greatest potential to affect short-term market volatility. The communications task force will likely examine the use of forward guidance, economic projections, and interest-rate projections. Meaningful changes to either rate projections or forward guidance could increase interest rate volatility. The rate “dots” in the current communications framework help anchor near-term expectations, particularly for the current year, while forward guidance has also helped dampen volatility over the past two decades. While former Fed Chair Jerome Powell recently indicated that he was unable to find a consensus around significant changes, there remains a reasonable probability that projections could be reformatted in a way that reduces the anchoring effect on near-term market pricing.

The Fed balance sheet will become smaller, but only gradually. Warsh has widely publicized his goal of a smaller Fed balance sheet, and recommendations from the task force are likely to be more broadly welcomed across the Committee. But concerns about unintended consequences suggest implementation will unfold only gradually over several years, as the Fed’s liabilities are intertwined with the banking system, and its holdings of Treasuries and mortgage-backed securities have implications for both Treasury financing and mortgage markets. We think the Fed may move toward a balance sheet that is more focused on Treasuries and less exposed to mortgage-backed securities, and that it may set clearer limits on future bond-buying programs. But any change is likely to rely mostly on runoff and reinvestment adjustments rather than active asset sales.

The balance sheet reform could reshape the longer-term bond market. A smaller Fed role means private investors would need to hold more long-term bonds, which could push up long-term yields, steepen the yield curve, and widen mortgage-backed security spreads. That would raise borrowing costs for companies and households, tightening financial conditions even if short-term interest rates do not rise. Still, the impact should be gradual and would depend heavily on Treasury issuance choices and bank regulation. If the Treasury issues more shorter-term debt, it could ease pressure on long-term yields. Regulatory reforms that reduce reserve demand could also support increased bank demand for Treasuries. For investors, this points to a long-term environment where bond duration risk matters more.

Specific changes are still to be seen, but we continue to recommend that investors maintain sufficient allocations to quality fixed income in their portfolios. We think the current yields offer an opportunity to lock in attractive income, particularly in short- and medium-maturity quality bonds. Select exposure to higher-yielding bond market segments such as emerging markets and high yield can also help investors build more diversified portfolio income.