I hope that the FOMC members, so voluble on so many topics, see fit to talk in detail about where they see the balance sheet stabilizing. Be that as it may, the pace of reduction and the guesses about the end-state imply that the Fed will allow the balance sheet to shrink gradually for about five years.
The Fed’s normalization statement pointed out that while it expects to use the federal funds rate to fight any recessions, the FOMC may restart reinvestment in the event of substantial interest rate cuts. If that occurs, that statement may serve as a signaling mechanism much like QE did. That is, some part of the effectiveness of QE was as a form of forward guidance. Basically the Fed told the market that it would not raise rates while it was buying bonds in the open market, and it promised to buy bonds for a certain period of time. That gave the market the assurance that the Fed would not raise rates for at least the length of QE. Going forward, if the Fed were to restart reinvestment, it may serve a similar psychological purpose.
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I do not expect sharp or substantial increases in bond yields as the result of the end of reinvestment. Various estimates put the effects of QE at about 100-200 basis points in the very short term, perhaps dissipating somewhat over time. As we will see in the next section, the US has plenty of reasons for low short-term rates. Combine that with low and steady inflation expectations, and there is good reason to think that long-term rates are mainly low for “natural” reasons. Witness, too, the sedate bond market since Fed Chairman Janet Yellen put balance sheet normalization on the agenda in her June 14th press conference.
Where will short term interest rates top out?
In the twenty years ended 2007, Fed funds averaged 4.85%. Absent a sustained rise in inflation, I do not expect rates will reach that level over the next five years. Even after the Fed has reduced its balance sheet, rates will likely remain low. The US trend growth rate is believed to have shrunk to about 2% per year. This estimate is nicely illustrated by the FOMC’s poll of its own voting members who expect longer run growth to be in the range of 1.8-2.0%. By way of comparison. GDP annual growth averaged about 3% in the 20 years ending in 2007.
The expectation for lower average growth in the years ahead is due to low productivity growth and the aging demographic. The productivity slowdown is not entirely understood, so it is possible that a productivity acceleration could mean a pick-up in growth in years ahead. For now, though, it seems that the slower trend growth will contribute to interest rates being lower in the years ahead than we might have expected. Another factor is also demographics—namely increased life expectancy in the US. A longer life tends to increase savings, which then increases the supply of funds destined for the fixed income market. (The relationship between economic growth and interest rates is discussed in this speech by Federal Reserve bank of San Francisco President John Williams.)
Both supply and demand for interest rates suggest that they will remain low in the future. Again, we can look at the FOMC’s poll of its own members who see short-term interest rates around 3% in the long run. Of course, the Fed may need to raise rates above that level to respond to bouts of inflation, but with inflation missing for so long, it seems unlikely right now.
Conclusions
The Fed’s normalization of its balance sheet is intended to be a dull affair. As long as no recession intervenes, in my view the Fed will also continue to raise interest rates over the next few years. I expect short-term interest rates to top out at very low levels compared to the period ending 2007. It would take inflation surprises to make me change my view.
John Eckstein is the CIO at Astor Investment Management, a participant in the ETF Strategist Channel.
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