Yields on U.S. Treasury declined; spread on some European sovereign debt narrowed noticeably. Growth of real gross domestic product (GDP) slowed during the first quarter. Inflation was lower than expected. Implied volatility in the equity markets was at a historically low level.
These are some of the highlights from Federal Open Market Committee’s (FOMC) recent meeting. FOMC members decided to keep the federal fund rate around 0.75% to 1%. More importantly, the investment policy is intact with persistent reinvestment of principal payments and rolling over of maturing securities. The Federal Reserve also proposed a plan to gradually unwind its $4.5 trillion balance sheet. The Standard & Poor's 500 has risen 0.52% since the press release.
Inflation was lower than expected
Change in yearly core consumer pricing stayed below 2%. According to the press release,
“Total U.S. consumer prices, as measured by the PCE price index, increased 1.75% over the 12 months ending in March. Core PCE price inflation, which excludes changes in food and energy prices, was about 1.5% over those same 12 months.”
Due to less-than-expected inflation, the Fed revised the inflation forecast slightly downward for 2017. The Fed also predicted inflation would remain below the 2% target by 2019.
Policy rate unchanged
The policy rate remains at 0.75% to 1%. Due to the slowdown in economic growth during the first quarter, the Fed hesitated to increase the rate. It was noted that the rate hike will come if economic growth remains on track. The Fed was unable to provide a reason for the current economic slowdown, citing transitory factors. The rate hike is delayed until there is additional evidence that the slowdown is temporary.
The big plan
While the interest rate was unaltered, the Fed mentioned a plan to slowly unwind its balance sheet. The Federal Reserve plans to decommission securities with smaller caps and then regularly increase the cap limit. Reinvestment will only take place over and above the cap limit. This allows the Fed to avoid disruption of financial markets that can be caused by the quick unloading of securities.
What does all this mean for the stock market?
The policy rate is unchanged, and reinvestment and rollover will continue. For now, it’s good news for stock markets. The Fed hinted toward a gradual decrease in its balance sheet, not at once. Well, at once isn’t possible. Loading off a large chunk of assets can break the market as there won’t be much of a demand for the securities the Fed is holding.
A gradual reduction will also have a negative impact on equity markets albeit slowly. Therefore, it is of utter importance for equity investors to follow the Fed’s balance sheet reductions closely. In current circumstances, it would be a good idea to consider market valuation relative to the Fed’s balance sheet, especially for index investors. Trimming equity positions as the Fed unwinds can protect investors from any downside risks.
Regarding the interest rate the Fed cited transitory factors for the slowdown. The statement lacks confidence as meeting minutes go on to note that additional evidence on whether the slowdown was transitory is awaited. All in all, an interest rate hike will be a difficult decision in current circumstances.
From the minutes, it doesn’t seem like the Fed will increase the interest rate or reduce its balance sheet in the near future. About the interest rate, FOMC decided to keep the policy rate as it is until it is sure that the current economic slowdown is “transitory.” Despite all of the easing policies, the Fed is unsure about consistent economic growth or stable inflation for that matter. This indicates the Fed’s lack of confidence and inability to increase rates or unwind the balance sheet. The point is giving a plan for action with conditions like “additional evidence for recovery” doesn’t constitute an actual plan to tighten policies.
“Members agreed that the slowing in growth during the first quarter was likely to be transitory. Members generally judged that it would be prudent to await additional evidence indicating that the recent slowing in the pace of economic activity had been transitory before taking another step in removing accommodation.”
The Fed’s unwillingness to act will keep boosting equity markets going forward.
Other key excerpts from the minutes
“Vulnerabilities appeared to have increased for asset valuation pressures, though not by enough to warrant raising the assessment of these vulnerabilities to elevated.”
“Several participants noted that downside risks to the global outlook remained, either because of geopolitical developments and foreign political factors or because monetary policy normalization in the U.S. could lead to financial strains in EMEs.”
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