FOMC round-up: markets are now hyper sensitive to inflation data - Westpac

Analysts at Westpac offered a round up of the FOMC.

Key Quotes:

Summary

The Fed raised rates by +25bp but the details are arguably on the hawkish side of a last minute recalibration of expectations - the dot plot median unchanged with 3 hikes this year and next, GDP growth expectations nudged fractionally higher, while Chair Yellen expressed confidence that recent soft inflation readings are transitory. Reinforcing the full steam ahead message, the Fed announced details of its balance sheet normalisation plans.

Balance sheet

On reinvestments, the Fed plans to decrease reinvestment in Treasuries by $6bn per month initially, growing by $6bn every 3 months until they hit $30bn, while Agency/MBS reinvestment will initially slow by $4bn per month, growing in steps of $4bn every 3 months until they hit $20bn. The Fed said the policy will be implemented “this year”.

The Treasury reinvestment plan, if implemented from Jan 2018 onward implies $180bn less in Treasury principal reinvestment in 2018, while on Agency/MBS their plan implies $120bn less in reinvestment in 2018, for a total $300bn reduction in the balance sheet in 2018. With the cap on Treasuries rising to a max $30bn after a year and to $20bn in Agency/MBS after a year the Fed’s balance sheet will be shrinking by $600bn per annum from the second year onward. At that pace principal reinvestment and the Fed’s balance sheet will fall off by a cumulative $1.5trn after 3 years.

Inflation and Markets

The USD and US yields rose after the Fed announcement, but only after recalibrating just ahead of the Fed announcement on a very soft May CPI. That data showed a soft 0.1% increase in the core CPI (even softer unrounded: 0.063%), with weakness broadbased, leaving the 3mth annualised core CPI flat, down sharply from 3.0% as recently as Feb 2017.

The statement appears to give a nod to the recent soft inflation readings, “…the Committee is monitoring inflation developments closely,” but Chair Yellen referenced several one-off items (wireless phone plan and prescription drugs price declines) that will restrain inflation only temporarily, that it is important not to overreact to recent soft inflation and that a strong labour market will eventually lift wages and inflation. The Fed’s PCE inflation projections match that confidence: 2017 was downgraded to 1.7% from 1.9% but 2018 and 2019 were unchanged at 2.0% and 2.1% respectively.

Dots

The dot plot medians are unchanged: 3 hikes still seen this year and next while the neutral rate was left unchanged at 3%. There is a slight dovish migration to the dots though - four participants now sit below the median this year and next, up from 3 forecasters who projected rates below the median this year and next year back in March.

Near term risks

The USD and yields clawed back earlier declines in the wake of the Fed announcement but on balance yields on the 10yr note and Fed Funds futures are closing lower on the day while the USD has shed some yield spread support in the back end of the yield curve. The Fed’s confidence on the inflation outlook leaves markets hyper sensitive to inflation data in coming weeks and months, inflation expectations in the Michigan survey 16 June and the PCE deflators 30 June obvious data points to watch. The Fed’s Dudley and Fischer speak next week too."