Fed Raises Rates, Announces Balance Sheet Reduction Plan

The Federal Reserve’s monetary policy committee announced two moves today with implications for housing. Neither represented a surprise for markets.

First, the Federal Open Market Committee (FOMC) announced the second rate increase for the short-term federal funds rate for 2017, raising the target rate to a 1% to 1.25% range. While the Fed continues to raise short-term rates, the current stance of monetary policy is accommodative given ongoing low rates of inflation. The FOMC has stated that in the medium-term, the committee’s objective for inflation is 2%.

The second policy announcement with housing market implications was the Fed’s plan for balance sheet reduction. As part of monetary actions enacted after the Great Recession, quantitative easing involved the Fed purchasing Treasuries and agency debt and mortgage-backed securities (MBS) as a means to hold down long-term interest rates. These holdings include approximately $1.8 trillion in MBS. Reducing holdings of MBS are expected to increase mortgage interest rates slightly, but the Fed’s announced plan will make these effects minor.

The announced policy sticks to the Fed’s plan to make this process “gradual and predictable.”  The Fed will begin balance sheet reduction by decreasing reinvestment of principal payments. This will occur by only making future reinvestments in excess of defined caps. For MBS, this monthly cap will start at $4 billion. The monthly cap will then increase in $4 billion steps in three-month intervals until rising to a $20 billion cap. The FOMC anticipates an incomplete reduction of the balance sheet, this leaving some share of current holdings in place. No specific date was announced for the beginning of this proposed policy, although a reasonable guess would be the end of 2017.

The Fed also stated its preference for the federal funds rate as its primary tool of monetary policy. However, the FOMC stated that it would utilize balance sheet expansion if economic conditions warranted additional stimulus and if reductions in the federal funds rate were insufficient for a future economic downturn.

Overall, the Fed’s announcement offered no surprises and represent a commitment to monetary policy normalization. The wild card concerning future Fed actions is the degree to which a low unemployment rate will spur growth in inflation.

 

 



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