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The Fed is managing expectations to control the US yield curve and the dollar

Macro Highlights - 9/26/2017

Key Takeaways of the week with Sophie Casanova, Economist, Central Banks, Lisa Turk, Economist, United States and François Léonet, Economist, Emerging Markets
  • In line with our expectations, the US Federal Reserve has announced that it will start gradually scaling back its balance sheet from October
  • It has also confirmed, as we forecast, that it could raise its Fed Funds rate by 25 bp to 1.50% at the end of 2017. Three rate hikes could follow in 2018, which is our scenario
  • However, it has cut its projection for the long-term Fed Funds rate from 3.00% to 2.75%, which means that the long-term neutral rate is 0.75%, as estimated by our models
  • This confirms our scenario for US rates to gradually increase, with the yield curve progressively flattening
  • The dollar could strengthen, in line with our forecasts, to 1.16$/€ by the end of 2017 and 1.12$/€ by the end of the first half of 2018
  • However, the lower long-term rate, which points to a monetary tightening cycle on a smaller scale than expected, could limit the dollar’s upside potential over the medium term
  • The upcoming renewal of several FOMC members could increase volatility on the fixed-income and currency markets on a short term basis, but is not expected to significantly change our scenario

The outcome of the Federal Reserve’s monetary policy committee (FOMC) meeting was fully in line with our expectations. Firstly, as we have been forecasting for several months, the Fed announced that it will start gradually scaling back its balance sheet in October. To achieve this, it will no longer be reinvesting all the amounts it receives when the securities it holds reach maturity, which, since the end of its last quantitative easing programme in 2014, had enabled it to keep the size of its balance sheet stable (see left-hand chart, p.4). From October, USD 6 billion of monthly redemptions of Treasury securities and USD 4 billion of monthly redemptions of MBS and agency securities that it holds will not be reinvested. These amounts will be gradually ramped up in line with the programme unveiled by the Fed in June 2017 (see table), paving the way for the Fed to gradually scale back its portfolio of securities and therefore the size of its balance sheet.  


Key elements on the slowdown in the Fed's reinvestments

The FOMC has announced last June its plans to scale back its reinvestments over the coming years. To achieve this, it will announce the monthly amount that it does not wish to reinvest.

This maximum amount or cap will be increased every three months during a 12 month period and then maintained until the Fed considers that the size of its balance sheet has decreased sufficiently.

For treasury bonds, the initial cap will be set at USD 6 billion and increased by USD 6 billion every three months until it reaches USD 30 billion.

For agency bonds and mortgage-backed securities, the initial cap will be set at USD 4 billion and increased by USD 4 billion every three months until it reaches USD 20 billion.

The Fed has announced its plans to reduce the size of its balance sheet compared with the level seen in the last few years, although it will still be higher than before the financial crisis. However, it has not given any indication concerning this amount.


n line with our expectations, the FOMC has kept the Fed Funds rate at 1.25%, while confirming that it intends to start raising it again between now and the end of 2017. According to the FOMC members’ forecasts, the Fed Funds rate could be 1.50% by the end of the year. In addition, these forecasts show that it could see three 25bp hikes next year, taking it up to 2.25% by the end of 2018, which is our scenario.

Lastly, the forecasts also revealed that a majority of the FOMC members estimated the Fed Funds rate’s long-term level at 2.75% (compared with 3.00% previously). This means that they see the long-term real neutral rate as 0.75%, which is in line with Mathilde Lemoine’s estimate for the neutral interest rate in the US.

Sophie Casanova, Economist, Central Banks