US Fed to rein in support next month and hike rates

US Federal Reserve chairman Janet Yellen. Joshua Roberts/Reuters

The US Federal Reserve moved to dismantle a pillar of crisis-era support for the world’s biggest economy and stuck with its forecast to raise interest rates again this year, saying hurricane damage won’t derail an otherwise healthy expansion.

“Hurricanes Harvey, Irma and Maria have devastated many communities, inflicting severe hardship,” the Federal open market committee (FOMC) said on Wednesday following a two-day meeting in Washington. “Storm-related disruptions and rebuilding will affect economic activity in the near term, but past experience suggests that the storms are unlikely to materially alter the course of the national economy over the medium term.”

In the statement, the Fed set October for the start of their previously announced plan to shrink its US$4.5 trillion balance sheet. As expected, policymakers left the benchmark interest rate unchanged in a range of 1 per cent to 1.25 per cent.

“We continue to expect that the ongoing strength of the economy will warrant gradual increases in that rate to sustain a healthy labour market and stabilise inflation around our 2 percent longer-run objective,” said the chairman Janet Yellen. She called this year’s inflation undershoot a “mystery”.

Treasury prices fell and the dollar rose as investors weighed the Fed’s plans to press ahead with gradual policy tightening. US stocks were little changed.

US central bankers are counting on steady growth and low unemployment to raise inflation closer to their goal, which would support their policy of gradual tightening through interest-rate increases and a reversal of quantitative easing.

“When the storm effects fade the economy will be as strong as before they hit, and that requires the gradual normalisation of policy to continue,” Ian Shepherdson, the chief economist at Pantheon Macroeconomics, wrote in an emailed note.

The announcement is a third big policy step by Ms Yellen, now in the final year of her term as Fed chair: she has overseen the end of large-scale asset purchases; the liftoff of rates from zero; and now the pullback from an unprecedented balance- sheet buildup without disruption to financial markets or the economy so far.

While the storms will temporarily boost inflation thanks to higher prices for gasoline and other items, “apart from that effect, inflation on a 12-month basis is expected to remain somewhat below 2 per cent in the near term but to stabilise around the committee’s 2 per cent objective over the medium term,” the Fed said.

The economy expanded at a 2.1 per cent annual rate in the first half - in line with the pace during this expansion - and US government 10-year notes yield about 2.24 per cent, down from 2.45 per cent at the start of the year. The Fed’s preferred price gauge rose 1.4 per cent in July from a year earlier.

“The labour market has continued to strengthen” and economic activity “has been rising moderately so far this year,” the Fed said. The FOMC repeated language saying “near- term risks to the economic outlook appear roughly balanced”.The decision to leave the target range for the federal funds rate unchanged and begin the balance-sheet run-off in October was unanimous. The Fed reiterated that interest rates are likely to rise at a “gradual” pace, though updated forecasts indicated that officials see the path as less steep than before.

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In their new set of projections, Fed officials estimated three quarter-point rate hikes would be appropriate next year - the same number they saw in June - based on the median in the so- called dot plot of interest-rate forecasts.

The Fed’s decision to exit from balance-sheet policies comes a decade after the global financial crisis began to tip the economy into a recession at the end of 2007. The reduction in assets will be slow - just US$10 billion a month to start.

“They have been very cautious,” said Drew Matus, the chief market strategist at MetLife Investments.

“Other countries went into quantitative easing and they are still stuck,” Mr Matus added. “The US is the first to get out.”

The Fed said the balance-sheet runoff would follow the framework released in June: $6bn in Treasuries and $4bn in mortgage-backed securities per month, rising every three months until the amounts reach $30bn and $20bn per month, respectively. The Fed anticipates ending the run off at some point, though it doesn’t yet have a specific date.

Minutes from the July meeting showed deepening worries about a prolonged period of low inflation. FOMC participants - including Fed governors and regional bank presidents - forecast that inflation will reach their 2 per cent target in 2019, compared with an expectation of 2018 in June, based on median estimates. They have missed the target for most of the past five years.

The quarterly projections also showed: four policymakers said the best policy would be to keep rates on hold for the remainder of this year, the same number as in the June projections; one person sought two more rate hikes this year, down from four officials previously; Fed officials held their longer-run estimate of the unemployment rate that corresponds to maximum labour resource use at 4.6 per cent while lowering their projections of the jobless rate in 2018 and 2019 to 4.1 per cent; policymakers lowered their long-run estimate for a federal funds rate that keeps supply and demand in balance in the economy to a median of 2.75 per cent, from 3 per cent in the June projections; the median estimate for economic growth in 2017 rose to 2.4 per cent from 2.2 per cent, while the core inflation forecast fell to 1.5 percent from 1.7 percent; long-run growth projection was unchanged at 1.8 per cent.

The decision to set the first balance sheet roll-offs for October was in line with the expectations of a majority of analysts surveyed by Bloomberg News ahead of the meeting. Economists had also forecast that Fed policymakers would maintain their projection for one more rate increase this year, and take that action in December.