The Fed’s Balancing (Sheet) Act

This post is also available in: French Italian German Polish

The Federal Reserve (Fed) left its benchmark interest rate steady at its September meeting, which was what the market had anticipated. The focus thus shifts to the beginning of the Fed’s reduction of its $4.5 trillion balance sheet, set to start in October. Even there, the Fed had been telegraphing the process would soon start, so that announcement was not a surprise either.

We think the pace of the reduction will be key to watch. The Fed announced the reduction would be slow—just $10 billion a month to start. It also reiterated the framework it had outlined in June of $6 billion in Treasuries and $4 billion in mortgage-backed securities per month, then slowly ratcheting up the amount.

Our general sense is that this pace had already been well-telegraphed, so the markets have responded pretty well. We think the market should be able to take the Fed balance-sheet reduction process in stride.

Fundamentally, the economic backdrop for the United States and globally remains positive, and this type of backdrop generally leads toward a constructive view on risk assets.

Connecting the Dots

The other big area of focus is the Fed’s “dot plot,” which is its projections for interest rates going forward. The Fed still is keeping its tightening bias, with one more rate hike projected this year and three next year. So the market is now focused on the December policy meeting.

For quite some time, the markets haven’t quite believed the Fed’s projections for interest-rate hikes as represented in the dot plots. The market has been more conservative in its view of the pace of rate hikes that would actually occur.

The Fed did bring down its long-term target rate to 2-¾% from 3%. In this cycle, the Fed conveyed that perhaps it didn’t need to raise rates as much as it has in past tightening cycles, and relative to what it thought a couple years ago. So we have some guidance in terms of where interest rates might go looking out longer term.

Remember, the Fed’s projections are just forecasts—which can change based on data.

And, the Fed has made it clear its decisions are data-dependent. So, the main reason the Fed has been reluctant to raise rates much is because inflation has been lower than the Fed anticipated it would be.

The market thinks the Fed will be extremely slow in its tightening, and I think there will still be some disconnect with the Fed’s projected pace going forward.

Transitory Data Impacts Noted

In its post-meeting statement, the Fed did mention temporary factors that could boost inflation, namely the hurricanes we have recently seen hit the United States.

As investors, we are aware of all the factors that could impact monetary policy—and our portfolios—but we try to look through short-term, transitory factors that don’t change the economy’s fundamental trajectory. These factors will impact data, but they aren’t ultimately the primary drivers of policy.

Our view is that inflation is not completely dead. We’d tend to think that ultimately, there will be a gradual pickup in inflation based on the positive fundamentals in the economy. That means the Fed will likely continue to gradually increase rates. It may not be at the pace the dot plots show, but we also think the market may be too conservative in its view that short-term rates are barely going up.

The comments, opinions and analyses are the personal views expressed by the investment managers and are intended to be for informational purposes and general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The information provided in this material is rendered as at publication date and may change without notice, and it is not intended as a complete analysis of every material fact regarding any country, region market or investment.

Data from third-party sources may have been used in the preparation of this material and Franklin Templeton Investments (“FTI”) has not independently verified, validated or audited such data. FTI accepts no liability whatsoever for any loss arising from use of this information, and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user. Products, services and information may not be available in all jurisdictions and are offered by FTI affiliates and/or their distributors as local laws and regulations permit. Please consult your own professional adviser for further information on availability of products and services in your jurisdiction.

Get more perspectives from Franklin Templeton Investments delivered to your inbox. Subscribe to the Beyond Bulls & Bears blog.

For timely investing tidbits, follow us on Twitter @FTI_Global and on LinkedIn.

What are the Risks?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. Floating-rate loans and high-yield corporate bonds are rated below investment grade and are subject to greater risk of default, which could result in loss of principal—a risk that may be heightened in a slowing economy.

CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute.