FOMC Minutes: Balance Sheet To Shrink This Year; Some Saw Stock Prices As "Quite High"

As previewed, the focus on the just released Fed minutes was on two things: the path of the rate hike, which the Fed said it can change its assessment if warranted, and on the future of the Fed's balance sheet, where the FOMC said said a reinvestment shift was warranted, suggesting that a balance sheet reduction would likely begin later this year.

  • MOST FED OFFICIALS SAW REINVESTMENT SHIFT WARRANTED LATER IN YR
  • FED: BOTH TREASURIES, MBS SHOULD BE PART OF REINVESTMENT CHANGE
  • FED OFFICIALS READY TO CHANGE RATE-PATH ASSESSMENT IF WARRANTED
  • FOMC TO CONTINUE DISCUSSING REINVESTMENT SHIFT AT UPCOMING MTGS
  • FOMC OFFICIALS DIVIDED OVER LEVEL OF SLACK IN LABOR MARKET

Key excerpts:

  • "Provided that the economy continued to perform about as expected, most participants anticipated that gradual increases in the federal funds rate would continue and judged that a change to the Committee’s reinvestment policy would likely be appropriate later this year."
  • "Many participants emphasized that reducing the size of the balance sheet should be conducted in a passive and predictable manner. Some participants expressed the view that it might be appropriate for the Committee to restart reinvestments if the economy encountered significant adverse shocks that required a reduction in the target range for the federal funds rate."
  • "An approach that ended reinvestments all at once, however, was generally viewed as easier to communicate while allowing for somewhat swifter normalization of the size of the balance sheet. To promote rapid normalization of the size and composition of the balance sheet, one participant preferred to set a minimum pace for reductions in MBS holdings and, if and when necessary, to sell MBS  to maintain such a pace.:"

To be sure, this is hardly the news the bond complex wanted, which has sold off following this latest warning that the Fed may begin shrinking its balance sheet. 

However the biggest surprise was in the latest caution by "some" Fed members that stock prices are quite high, and that the Fed is increasingly worried about asset bubbles, to wit:

  • SOME FED OFFICIALS VIEWED STOCK PRICES AS `QUITE HIGH'

Here is the section in question:

In their discussion of recent developments in financial markets, participants noted that financial conditions remained accommodative despite the rise in longer-term interest rates in recent months and continued to support the expansion of economic activity. Many participants discussed the implications of the rise in equity prices over the past few months, with several of them citing it as contributing to an easing of financial conditions. A few participants attributed the recent equity price appreciation to expectations for corporate tax cuts or to increased risk tolerance among investors rather than to expectations of stronger economic growth. Some participants viewed equity prices as quite high relative to standard valuation measures.

And this:

"Stock prices rose across most industries, and equity prices for financial firms outperformed broader indexes. Meanwhile, spreads of yields on bonds issued by nonfinancial corporations over those on comparable-maturity Treasury securities were little changed."

And then the punchline, which confirms that the Fed is only focused on the S&P: The Fed explicitly warns of "downside risks" to its forecasts if "financial markets were to experience a significant correction."   The passage in question:

... a number of participants remarked that recent and prospective changes in financial conditions posed upside risks to their economic projections, to the extent that financial developments provided greater stimulus to spending than currently anticipated, as well as downside risks to their economic projections if, for example, financial markets were to experience a significant correction. Participants also mentioned potential developments abroad that could have adverse implications for the U.S. economy.

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Below are selected excerpts from the FOMC meeting minutes that concluded on March 15, via BBG:

  • When the time comes to implement a change to reinvestment policy, participants generally preferred to phase out or cease reinvestments of both Treasury securities and agency MBS.
    • The staff provided several briefings that summarized issues related to potential changes to the Committee’s policy of reinvesting principal payments from securities held in the SOMA. These briefings discussed the macroeconomic implications of alternative strategies the Committee could employ with respect to reinvestments, including making the timing of an end to reinvestments either date dependent or dependent on economic conditions.
    • The briefings also considered the advantages and disadvantages of phasing out reinvestments or ending them all at once as well as whether using the same approach would be appropriate for both Treasury securities and agency mortgage-backed securities (MBS).
    • Nearly all participants agreed that the Committee’s intentions regarding reinvestment policy should be communicated to the public well in advance of an actual change. It was noted that the Committee would continue its deliberations on reinvestment policy during upcoming meetings and would release additional information as it becomes available.
  • Some participants viewed equity prices as quite high relative to standard valuation measures. It was observed that prices of other risk assets, such as emerging market stocks, high-yield corporate bonds, and commercial real estate, had also risen significantly in recent months.
  • With their views of the outlook for the economy little changed, participants generally continued to judge that a gradual pace of rate increases was likely to be appropriate to promote the Committee’s objectives of maximum employment and 2 percent inflation.
    • In contrast, several other participants cited evidence that some slack remained in the labor market, such as still-modest aggregate wage growth and the unevenness of wage gains across industries, an elevated share of employees working part time for economic reasons, or other broad measures of labor underutilization.
    • In contrast, participants held different views regarding prospects for the attainment of the Committee’s inflation goal. A number of participants noted that core inflation was a useful indicator of future headline inflation, and the latest reading on 12-month core inflation suggested that it could still be some time before headline inflation reached 2 percent on a sustained basis.
  • Several participants now anticipated that meaningful fiscal stimulus would likely not begin until 2018. In view of the substantial uncertainty, about half of the participants did not incorporate explicit assumptions about fiscal policy in their projections. Nonetheless, most participants continued to view the prospect of more expansionary fiscal policies as an upside risk to their economic forecasts.
  • Participants generally viewed the downside risks associated with the global economic outlook, particularly those related to the economic situation in China and Europe, as having diminished over recent months.
  • Although motor vehicle sales had fallen early in the year and some other components of PCE had also declined, many participants suggested that the slowdown in consumer spending in January would likely be temporary. The slowing appeared to mainly reflect transitory factors like lower energy consumption induced by warm weather or delays in processing income tax refunds.
  • Nearly all participants judged that the U.S. economy was operating at or near maximum employment.
  • Participants emphasized that they stood ready to change their assessments of, and communications about, the appropriate path for the federal funds rate in response to unanticipated developments.

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And the full minutes (link):