QNB: Fed More Likely To Use Rates Than Balance Sheet To Tighten Policy

Doha, QNB Group expected two rate hikes from the US Federal Reserve (Fed) in 2017, starting in either May or June the first half of the year. The Fed is unlikely to start reducing its balance sheet before mid-2018.

In its weekly economic analysis, QNB Group said Fed has been in the spotlight recently. There have been questions about how the Fed would respond to President Trump’s economic policies, especially his projected fiscal stimulus. There has been a debate about the timing of the next rate hike in light of strong data recently. And there has been a focus on the Fed’s balance sheet and the strategy to reduce it, triggered by comments from a number of Fed officials.

The US economy is expected to grow by 2.0% in 2017. This should reduce the unemployment rate by 0.2% to 4.5% at end-2017 compared to a year earlier and core inflation is expected to rise by 0.1% to 1.8% over the same period, according the analysis.

Using the Fed’s standard rule linking interest rate decisions to inflation and unemployment (the so-called Taylor Rule), the magnitude of improvement in economic conditions suggest two rate hikes. Financial markets are in line with this logic, as they are also currently pricing in two rate hikes.

On the timing of raising interest rates next, the analysis said Fed may decide to wait until May or June are more probable as they this would give Fed time to get more clarity on Trump’s economic policies and how they might impact the economy.

More importantly, and potentially more disruptive for financial markets, is the question of the Fed’s balance sheet, the analysis said, noting that after the Fed pushed short-term interest rates close to zero in late 2008, its main tool for tackling the recession became reducing long-term interest rates through multiple quantitative easing (QE) operations.

These involved purchasing large quantities of government bonds and government-backed securities, which resulted in the Fed’s balance sheet ballooning from around USD900bn to about USD4.5tn currently, it said, pointing out that QE was exceptional in its scope and size and was always expected to be unwound at some point.

In light of these arguments, the report did not expect the Fed will rush to reverse QE and reduce its balance sheet. As a result, it expects this process to begin until sometime in 2018, stressing that in the meantime, the Fed will continue raising short-term interest rates in a gradual manner.

This means two rate hikes for the whole of 2017, the analysis concluded.

Source: Qatar News Agency