Pivot to Neutral

When the policy-setting arm of the Federal Reserve meets on March 19-20, Fed Chair Jay Powell will be walking a tightrope to acknowledge that economic indicators have come in even weaker than when the Federal Open Market Committee (FOMC) last met in January, without triggering too much concern about the outlook for growth. The statement after the meeting will have to balance weakness in the current quarter, disappointment over household spending and optimism about business investment. The recent durable goods orders suggest that businesses may be regaining some of the optimism that they lost near the end of 2019.

We expect to see the consensus forecast for 2019 to be marked down again. The number of rate hikes on the “dot plot’ of forecasts will fall to only one this year. We also expect Powell to go to great lengths to take the focus off of the dot plot because it is not an actual trajectory for rate hikes; the dots indicate members’ individual forecasts for the economy.

The Fed is expected to announce plans to halt reductions in its balance sheet. That will reinforce the message that the Fed is pivoting to neutral, putting both rate hikes and the balance sheet on hold. It will likely take until June to bring the balance sheet roll-off to an end; the FOMC has yet to come to a consensus on the optimal size and composition of its balance sheet. The only thing we know for sure is that FOMC members believe the balance sheet should be larger than it was in the past. The Fed held about $800 billion on its balance sheet prior to the crisis; that is less than a quarter of the size of the balance sheet today.

One of the major changes on the Fed’s balance sheet is the size of bank reserves, which has risen dramatically since the crisis. The reserves mean that banks can borrow directly from the Fed instead of lending overnight funds to each other, making the system less susceptible to panics. The question is, what is the optimal level for reserves in good economic times? Most within the Fed believe it is somewhere between $800 billion and $1.2 trillion, but that decision has to be made.

Then comes the composition of the Fed’s balance sheet, which currently includes a mix of Treasury bills and mortgage-backed securities. There is a preference among many on the FOMC to allow the crisis-era portfolio of mortgage-backed securities to continue to run off and replace those assets with Treasury bills. There is still disagreement over whether the focus should be on holding short or long-term maturities. Those who prefer short-term maturities argue that would keep the Fed’s balance sheet more liquid. This would also shelter the Fed from concerns that it is simply monetizing debts and deficits down the road.

Finally, we expect the chairman to be asked what the Fed has in its tool box, should the economy falter. He has previously stated that negative interest rates are a possibility. The FOMC has yet to decide on this latter point but will be examining the issue along with the optimal size and composition of the balance sheet.

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