As Fed Sets to Unwind, How Far Should It Go?

As Fed Sets to Unwind, How Far Should It Go?”

If the focus is on the repurchase of short-term assets, that would likely push the long end of the yield curve higher, driving investors' attention also to shares of banks, which would theoretically make more money with the help of higher net interest margins, said Morganlander. The Fed would allow assets to mature without reinvesting the totality of those maturing assets, which would trim some $300 billion from the Fed's portfolio after the first year according to analysts.

The classical view is that conditions are too easy, which has led to something of a bubble in risk assets prices, by which it is meant the stock market, and this is risky.

But with its balance sheet reduction plan operating in the background, the Fed will be putting upward pressure on borrowing costs each month regardless of what it does with its benchmark interest rate.

Just as the Fed had never before engaged in a bond-buying spree of such magnitude, it has never attempted to shrink a portfolio that is now roughly five times its size before the financial crisis.

"I think the two hurricanes are going to give the Fed pause about raising rates again until they have a better idea of the economic impact", said Sung Won Sohn, an economics professor at California State University, Channel Islands.

Anyone ruling out a December rate increase "is mispricing the real desire on the part of the Fed to continue" normalizing monetary policy despite the dip in inflation, said Jason Celente, senior portfolio manager at Insight Investment.

The slow and steady move would not turn the Fed into a seller.

Any damage in the markets could also extend to assets such as stocks, which have set record highs as investors have shifted money into stocks and away from low-interest bonds.

The Fed will update its economic forecasts, which are compiled from the projections of its board members and the 12 regional Fed bank presidents. Policy makers have outlined a plan where the central bank would allow $6 billion of Treasurys and $4 billion of mortgage bonds to mature each month without reinvesting the proceeds in new securities.

But the central bank has been going backward in trying to meet its other mandate of stabilizing prices at an annual inflation rate of 2 percent over time.

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. A critical question is whether the Fed has grown troubled or confused about chronically low inflation.

And adds, "This may well be the same conclusion that Yellen articulates in the press briefing this week, which on its own shouldn't prompt any major re-pricing of Fed policy expectations".

It has been stubbornly low for years. More recently, she has wondered whether something more widespread might be keeping inflation low.

If Yellen leaves - and analysts think on balance she probably will - her replacement and what sort of policy strategy the new governor will follow, are further cause for increased uncertainty.

Referring to the Fed's projection of member's expectations of future interest rates, illustrated in a dot plot diagram on the Fed's website, where dots represent each of the 16 voting and non-voting Fed member's projections of future interest rates, he suggests the main clusters of dots - or median expectation - may drop.

"Ongoing balance sheet reduction at the same time fed funds rate hikes continue at the same pace as this year might be too much tightening too soon for the expansion to bear without adverse consequences", Anderson said. She will certainly be asked.

Then there are geopolitical jitters emanating from North Korea and the recent departure of deputy governor Fischer means the Fed could be in peril of having its "head lopped off" when Janet Yellen's term also comes to an end in January 2018. He said of the Fed chair last week, "I like her, and I respect her".

President Donald Trump has indicated that he is considering asking Yellen to serve another term. It's reported that he is considering a variety of other candidates including his economic advisor, Gary Cohn. She has not indicated whether she would or wouldn't accept a Trump offer to serve another term. So far, Trump has moved to fill only one spot, nominating Randal Quarles, who has yet to be confirmed by the Senate, to the key post of vice chairman for bank supervision.

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