As expected, the Federal Open Market Committee (FOMC) reduced the fed funds range by another 25 basis points to 1.75%–2.00% at its September meeting, making this the second cut since the Federal Reserve stopped hiking interest rates last December. However, we see two bigger takeaways from Wednesday’s meeting. First, Fed officials remain divided on the appropriate near-term path for interest rates; and second, the Fed could announce a change to its current balance sheet policy as early as October.
Despite the distribution of FOMC views, we continue to believe that a majority of the current voting members prefer to ease monetary policy again in the coming months, and that some further deterioration in economic data will eventually get more members on board.
A divided committee
Wednesday’s release underscores how divided the committee remains over the appropriate near-term policy path. Although all members likely downgraded their forecast for the level of interest rates at the end of 2019, there was disagreement around how much more accommodation will be appropriate. Seven members projected another rate cut by the end of this year, while five currently prefer to hold rates steady. But perhaps most strikingly, five participants went into this week’s two-day meeting preferring not to cut the benchmark rate.
Based on past communications, members appear to disagree on the relative costs and benefits of further cutting interest rates. Indeed, in the context of moderate inflation and limited room to ease policy, some see enough sources of economic weakness and policy uncertainty to warrant a more preemptive approach to easing financial conditions. However, others view the recent slowdown in growth as consistent with previous forecasts for some cooling as the positive effects of last year’s fiscal stimulus fade and the labor market approaches a plateau. These members also view financial stability risks as sufficiently worrisome to hold back.
Ultimately, we think a majority of the current voting FOMC members prefer to ease monetary policy again in the coming months, and that other members will get on board if economic data deteriorate further. And while we agree that fading fiscal stimulus has contributed to slower U.S. growth this year, the weakness in the economy likely also reflects spillovers from a more worrisome cyclical downturn in the global economy along with U.S. trade policies, which have disrupted normal trade, inventory, and production activity. We think this weakness, which has contributed to the recent loss of momentum in the labor market, makes the economy vulnerable to shocks and argues for more easing later this year.
Funding market stress
Despite the recent bout of severe stress in money markets, the Fed did not make any adjustments to its current balance sheet policy, nor did it announce a standing repo facility. Instead, Fed Chair Jerome Powell highlighted the temporary repo operations undertaken this week by the New York Fed in an effort to stabilize money market yields and gain greater control over its benchmark overnight unsecured funding rate. Powell also hinted that more permanent actions could be taken as early as the October meeting.
Earlier this year, we estimated that the minimum level of reserves demanded by banks to meet various post-crisis regulations, including the liquidity coverage ratio, was around $1 trillion, but that a buffer of $300 billion – $400 billion would be needed to ensure against unintended bouts of money market volatility. With reserve levels currently between $1.4 trillion – $1.5 trillion, the recent money market volatility and elevated effective federal funds rate suggest that bank reserve demands may be somewhat greater than initially thought or that the “buffer” needed may be larger for the Fed to continue to set monetary policy under a system of ample reserves.
Weighing the Fed’s options
If this is the case, the Fed will likely move forward its plans to stem the current decline in reserves resulting from growth in currency in circulation by buying additional assets. And over the next several months, the Fed will need to decide on the long-run composition of the assets it holds. The Fed has already signaled that it prefers to hold Treasury securities over agencies and agency mortgage-backed securities (MBS). However, the FOMC has not yet revealed its policy for the maturity composition of its Treasury holdings.
Various approaches have been proposed, including matching the weighted average maturity of Treasuries outstanding or holding shorter-dated Treasury bills. Balancing the various benefits and costs of each approach, we think it’s possible the Fed will announce a combination of the first two policy options, whereby the Fed continues to reinvest the proceeds from maturing Treasury and agency securities across the Treasury curve, while managing reserve levels through shorter-dated Treasury purchases.
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Tiffany Wilding is a PIMCO economist focusing on the U.S. and is a regular contributor to the PIMCO Blog.