The FOMC surprised the markets somewhat by issuing two policy statements, not only one as in the past. But, the second statement was merely a reminder that the fed funds rate is the primary policy tool, not the size of the balance sheet. With a huge volume of reserves in the banking system, control of the fed funds rate is accomplished with the Fed’s administered rates–meaning the rates paid on those reserves. Managing the volume of reserves is not a viable strategy for controlling the funds rate. Balance sheet normalization (draining $50 billion per month by not reinvesting all the cash flow from its holdings of Treasuries and mortgage backed securities) will continue. But the Committee is prepared to adjust the normalization process if economic fundamentals were to change.
The traditional policy statement read as expected. No change in the fed funds rate but also no meaningful change in their view of the economy. They cited strong labor markets and healthy consumer spending as reasons for expecting continued solid growth. They will be patient as it decides on future increases in the funds rate. That change in the statement was a reaction to the “global economic and financial developments” in December and early January. They dropped the line that said that further gradual rate increases in rates were likely. This is viewed as a signal that there will be no increase in the funds rate at the March meeting.
In sum, the reduction in the balance sheet will continue at around the current pace. If a near-term policy adjustment is needed, it will be a change in the fed funds rate, not in the balance sheet strategy. No surprise here. The majority of the Committee still appears prepared to approve several more increases in the fed funds rate, but those increases will probably occur in May or June. That policy path will be data dependent (as always) so data such as employment, spending and the YOY core PCE deflator will continue to be crucial.
Chair Powell also cited weakness in foreign economies as another factor they will be monitoring. He also said that in recent weeks the case for raising rates has weakened some. That was probably the most important statement of the day. They will want to be sure that some of the “crosscurrents” have eased before they consider another rate increase. It will take several months of healthy data to convince the Committee that another rate increase is appropriate.