US: Fed puts exit on hold – we postpone hikes to Q4 2011

August 10th, 2010 | by Cheryl Hills |

The Fed announces its intention to reinvest principal payments from Agency and MBS holdings in longer term Treasuries.
Such a move will maintain a constant Fed balance sheet and, for now, effectively postpones the exit process.
We postpone hikes to Q4 2011.

Details

Statement language clearly indicates that the Committee has been negatively surprised by recent weak economic data. Members have revised downward their near-term outlook while reiterating their medium-term expectation of a gradual recovery.

Incoming data and their outlook consequences have apparently been severe enough for the Committee to justify sending a strong signal to the market. The decision to reinvest principal payments from its portfolio of Agency and MBS holdings in longer term Treasuries implies that Fed balance sheet size will remain constant. Originally it was projected to contract by USD150-200bn p.a.

Given the balance sheet’s already substantial size at around USD2000bn, such numbers are very modest. More important is the signal embedded in the decision itself, which effectively postpones the exit process for now. It provides a clear indication that rate hikes remain in the indefinite future and that the central bank is prepared for another round of quantitative easing if necessary. Such ‘verbal QE’ is much more important than the implication represented by balance sheet figures. The intention is to keep long bond yields gridlocked at current very low levels for a prolonged period, in itself probably the most effective way to ease financial conditions and stimulate growth.

Interestingly, the decision was announced to buy longer-term rather than short-dated Treasuries, one reason for which may be to indicate a stronger commitment to supporting the economy and maximizing the impact on long term funding costs.

Finally and significantly, Hoenig dissented again. He voted against both the decision to retain ‘extended period’ language and the determination to reinvest principal payments from Agency and MBS holdings.

Assessment and outlook

If data deteriorates further, the Fed’s next step would entail further QE. Given our main scenario involving a soft landing in H2, this is not our baseline although given a softer H2 outlook and the FOMC shifting to an easing bias, we revise our Fed funds forecast. We now expect a first Fed hike in Q4 2011. We will publish revised yield forecasts on Friday incorporating this change.

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