Bank of the West – Instant Analysis of the July FOMC Statement

As we expected, the FOMC dropped a big hint in today’s FOMC  statement that implementation of the Fed’s balance sheet normalization plan will be implemented “relatively soon”.  I take that to mean an announcement at the next FOMC meeting on September 20th with asset reductions beginning in October.
The FOMC helped the market digest the news of balance sheet normalization by softening the language on inflation, which the bond and Fed funds futures markets took to mean a lower probability of additional rate hikes this year and into 2018.  The July FOMC statement replaced the language the inflation was running “somewhat below” 2 percent with more downbeat language that inflation was running “below” 2 percent.  While clearly a nod to more dovish FOMC members like Neel Kashkari, who dissented with the majority at the last FOMC meeting, I don’t see this as a material change in the FOMC thinking around the inflation outlook, or rate hike outlook for that matter.  The statement kept the language on the outlook for inflation intact
Fed funds futures now puts only a  38.5% probability of another interest rate hike from the Fed by December. It appears the markets see balance sheet normalization and fed funds rate hikes as substitutes rather than compliments today.  A higher probability of balance sheet reduction means a lower probability of further rate hikes from the Fed.  I am not so sure that is the way the FOMC is thinking about this impending action, I still think the FOMC sees the two monetary policy actions- balance sheet normalization and Fed rate hikes as compliments that are not inherently mutually exclusive.  Stocks and Treasury bonds rallied on the news, and the U.S. dollar weakened to 14 month lows.
On the economy, the statement slightly upgraded the assessment of the labor market, noting that job gains have been solid, while household spending and business investment continued to expand.

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