07.04 Weekly Viewpoint : FOMC minutes: opening the way towards a smaller balance sheet

Draghi spoke out making clear there is no urgency to modify the guidance on monetary policy given the inertia of core inflation and wages……

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The minutes of the FOMC meeting held on 15 March as expected provided fresh information on the reinvestment policy. The central bank’s assessment of the macroeconomic picture remained positive. Participants were not concerned by the slowdown in GDP growth expected in 1Q, caused by temporary factors. Risks were considered “roughly balanced”, tied in part to fiscal stimulus, which in any case, according to the majority, should not reap effects before 2018. As for financial developments, financial conditions were considered still accommodative, and several participants stressed the role played by the stock market rally. In the discussion on monetary policy strategy, participants generally deemed it appropriate to hike rates gradually, so as to keep conditions accommodative, to allow inflation to reach and stably remain close to 2%. The expected path of gradual rate increases will in any case be reviewed based on the evolution of the scenario and of risks, both upside and downside.

For what concerns balance sheet policy, the Committee confirmed that asset purchases should remain an instrument to be used in exceptional cases, only after the margin allowed by interest rates cuts is exhausted. Participants agreed on the fact that the reduction in the Fed’s securities holdings should be gradual and predictable, and mostly accomplished by phasing out reinvestments (rather than through sales). In terms of timing, most participants believed it appropriate to consider changes to the reinvestment policy based on economic and financial conditions. “Several” participants said that the reduction in the size of the balance sheet should be based on a fed funds rate threshold, whereas others would prefer a more “qualitative” rule. Some recent speeches (for instance Dudley) indicated that the Fed may implement two hikes, and then take a “short pause” during which to start tapering reinvestments, before resuming hiking rates in 2018. Most participants stressed that the tapering of reinvestments should begin by the end of the year and be conducted in a “passive and predictable” manner, involving both Treasuries and MBS. For now, there is consensus on a gradual reduction of reinvestment purchases. In conclusion, the minutes have not changed the expectations built up over the past two weeks, pointing to two hikes (possibly June and September), followed by the start of a tapering of reinvestments in the autumn.

The minutes of the ECB March meeting confirm that Members discussed whether it was appropriate to change the guidance on rates and in particular to attenuate the easing bias by lifting the reference “to lower rates”. Members broadly agreed “that the easing bias was an integral part of the guidance” and that “changes in the formulation at the current juncture could lead to an undue upward shift in financial conditions to an extent that was not warranted by the prevailing outlook for price stability”. The minutes only confirm what has become evident in the past weeks: the debate on exit form unconventional measures has already started. Last Thursday, Draghi spoke out making clear there is no urgency to modify the guidance on monetary policy given the inertia of core inflation and wages. Draghi stressed that the monetary policy stance is the result of several instruments: negative rates, the APP which is time- and state-dependent, and the guidance. Our forward guidance is de facto on the entire package, not on any specific component of it. And this guidance relates not just to the conditions under which we would withdraw stimulus …but also to the sequence of measures. ” Draghi rejected criticism of the negative rate regime, indicating that on balance it is supportive not only for the whole economy but also for banks, as the drop in interest income is balanced by larger lending volumes. However, Draghi acknowledged that the probability of lower rates has decreased. The inertia of core inflation limits urgency to introducing changes to communication on monetary policy. However, if growth at more than solid rates continues in the coming months, it is reasonable to expect the ECB to start preparing the markets for a gradual normalisation of monetary policy.

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