US Fed balance sheet unwinding

Under efforts to "normalize" US monetary policy, the Federal Reserve (Fed) announced Wednesday that it would gradually reduce the size of its bond holdings, worth about $4.5 trillion (3.75 billion euros), beginning in October. The massive amount of assets was accumulated by the Fed in the wake of the 2007/2008 financial crisis, and under a program called "quantitative easing" (QE), intended to spurr economic activity in the United States..

The decision comes as the US central bank sees economic activity "rising moderately," with a labor market that "continued to strengthen" creating "solid" job gains since the Fed's last meeting in July.

As a result of the economic projections, policymakers on the rate-setting Federal Open Market Committee (FOMC) left US benchmark interest rates steady within a range of 1-1.25 percent — a move that was widely expected by analysts.

However, 11 of the 16 Fed officials saw the "appropriate" level for the federal funds rate to be in a range between 1.25 percent and 1.50 percent by the end of the year, increasing the likelihood of a third rate hike at the FOMC's next meeting in December.

A matter of years, not months

Markets have shown no signs of trepidation in advance of the start of the tapering process. The resolution of the stand-off over the US debt ceiling in Congress has removed the final obstacle to the decision, which the Fed said would proceed at a fixed monthly level that can be adjusted as needed to be either faster or slower.

At the moment, the central bank reinvests the payments it receives on the portfolio of government bonds and mortgage-backed securities (MBS), keeping its holdings steady. So the first step will be that the Fed stops reinvesting the proceeds, rather than outright sales.

The initial cut in reinvestment would be capped at $10 billion, Fed Chairwoman Janet Yellen told a news conference after the two-day meeting. They would increase in three-month intervals until they peaked at $50 billion in about a year from now, she added. With the Fed's shrinking balance sheet, a source of liquidity for markets will dry up, likely resulting in a small increase in interest rates.

Murky outlook on rates

By contrast, the prospects for US interest rates are far more unclear. Policymakers have been divided in recent months on the near-term threat of inflation. The Fed's preferred measure of inflation was down to 1.4 percent on an annualized basis as of July, well short of its medium-term 2 percent target.

"Inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the 2 percent objective over the medium term," the central bank said in its statement.

Some of the FOMC members have argued the central bank should be patient before raising rates again. But other policymakers were concerned about financial market risks that could build up if rates remain low too long.

As things stand, the interest rate outlook for next year remains largely unchanged, with three hikes envisioned. But the Fed may slow the pace of projected monetary tightening from there.

It forecasts only two increases in 2019 and one in 2020. It also lowered again its estimated long-term "neutral" interest rate from 3.0 percent to 2.75 percent, reflecting concerns about overall economic vitality.

uhe/bb (Reuters, AFP, dpa)