It’s that time again. The Federal Reserve’s rate-setting Federal Open Market Committee will hold its monthly meeting on Sept. 19–20. What should we expect?
Two headline issues stand out: First, Fed officials look set to leave the central bank’s benchmark short-term interest rate steady at its current range of 1.0% to 1.25%. Second, they are likely to announce that they will start scaling back the Fed’s massive bond holdings in October.
Other subjects also bear watching, but we’ll start with those two.
Fed officials have dropped some public hints about their plans to keep interest rates on hold at the coming meeting, so a hike would definitely be a surprise. The bigger question is whether they will stick with their projection of another rate hike later this year, most likely in December. And that will depend on the economy.
By law, the Fed is tasked with using its monetary tools to keep unemployment low and inflation under control. The first part of that mandate has been humming along nicely. At 4.4% in August, the unemployment rate remains low and is approaching the Fed’s median projection for 2017 of 4.3%.
Inflation has been trickier—and is exhibit A in why the Fed hasn’t been able to get rates back to normal more quickly. Normally, when unemployment is this low, the expectation is that an increase in inflation can’t be far behind, as employers could start offering higher wages to compete for a shrinking pool of available employees. However, inflation actually softened earlier this year.
Prices firmed up in August, but it’s unclear whether that will be enough. The Fed’s preferred measure of inflation is still below its 2% target—the core deflator for personal consumption expenditures (PCE) fell to a 1.4% rate in July from 1.9% at the beginning of the year—but Fed Chair Janet Yellen has suggested that weakness was temporary and expected.
Whether the economy has shaken off those temporary effects remains to be seen, but the August data could give the Fed the evidence it needs to stick with its plans for another hike this year.
“Right now, by most measures, inflation is running at about 1½%. And it’s not just in the U.S.—it’s falling globally,” says Kathy Jones, senior vice president and chief fixed income strategist at the Schwab Center for Financial Research. “And despite that, though, we think that there’s still a chance that the Fed could raise rates later this year at the December meeting.”
Balance sheet plans
It’s also important to remember that the Fed may soon start tightening monetary conditions by shrinking the $4.5 trillion pile of assets it acquired in the wake of the financial crisis. The Fed announced the plan at its June meeting—but not the start date. That could change, with Fed officials widely expected to say the reduction will start in October.
The plan will work like this: By reinvesting the principal from maturing assets, the Fed has kept its holdings steady ever since it stopped adding to the pile back in 2014. Those reinvestments will soon stop. Once they do, the Fed will allow $10 billion of maturing bonds to drop off its balance sheet each month—$6 billion in Treasuries and $4 billion in mortgage-backed securities. That will continue for three months and then increase over time.
The Fed’s asset purchases have provided a steady source of demand in the bond market for years, but the market’s reaction to the Fed’s plans has been pretty muted. Bond yields remain low.
Fed watchers will be on the lookout for clues about several other issues when the two-day meeting comes to a close.
- The post-meeting press conference. Because Fed-watching can be both an art and a science, observers will be listening not just to what Yellen says about the economy, but also how she says it. If she’s explicit about the need to tighten more, markets could take that as a sign of strength, potentially sending yields higher. Conversely, a more “dovish” tone could keep yields low.
- Personnel changes. Fed Vice Chair Stanley Fischer recently announced that he’s going to be leaving in October, adding to the open seats at the central bank. Meanwhile, Yellen’s term as chair is slated to end in the spring, and she will surely be asked at the press conference whether she would like to be reappointed. “When Fischer leaves, four out of the seven seats on the Board of Governors will be open, and if Yellen leaves, that would be five out of seven,” Kathy says. “President Donald Trump has already put one nominee for a seat forward, and through his future additions he could have the opportunity to reshape the Fed’s approach not just to monetary policy, but also to bank regulation.”
- The “dot plot.” The Fed will also release an updated version of its “dot plot” chart, which tracks projections for economic conditions as well as forecasts for the future path of interest rates. “There is some chance that the dots for 2017—i.e., December—will show the committee is divided on a rate hike,” Kathy says. “It's also possible the Fed's forecast of where rates will peak in the future will be lower than the Fed's previous expectations of a longer-run rate of 3%.”
What investors can do
Overall, the Fed seems determined to get interest rates back to a more normal setting, so investors should structure their bond portfolios accordingly. Because longer-term bond yields tend to be more sensitive to interest-rate changes than shorter-term bonds, Kathy suggests keeping the average duration of your fixed income portfolio in the short-to-intermediate term for now. That can allow you to diversify across maturities, while limiting your exposure to maturities that might see their prices wobble as the Fed pushes interest rates higher.
What you can do next
Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982.
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