MNI PRE-FOMC: Economy On Track, Fed Turns to Balance Sheet

By Jean Yung

     WASHINGTON (MNI) - Federal Reserve officials heading into their November

meeting appear undeterred from their resolve to gradually lift interest rates

over the next year, despite continued market turmoil. 

     As stock markets plunged in October, two regional Fed presidents, Loretta

Mester of Cleveland and Rob Kaplan of Dallas, on the eve of the Fed's

communication blackout period reiterated the need to keep moving rates toward

neutral. 

     The most recent growth, inflation and employment figures will likely

reinforce the outlook. Third-quarter GDP grew at a robust 3.5% as consumer

spending surged, while the core PCE price index, an indication of underlying

inflationary pressures, continued to hold near 2% where it has been since March.

     The October employment report Friday showed another 250,000 jobs added to

the economy and the unemployment rate steady at 3.7%. Wage gains appear to be

broadening as well across various measures. 

     At the September meeting, 12 of 16 Fed officials saw a fourth rate hike

this year to a target range of 2.25% to 2.5%, while a slim majority -- nine out

of 16 -- saw three or more rate hikes next year. While no action is expected

next week, fed funds futures traders are pricing in a roughly 70% probability of

another 25-basis point rate hike in December, and the post-meeting statement

Thursday is unlikely to swing odds in either direction. 

     --INVESTMENT SLOWING 

     Not all data has been upbeat. A slowdown in business investment and housing

have some analysts wondering if the Fed is hiking rates well beyond what's

necessary and accidentally engineering a hard landing along the way. 

     Home sales and building permit activity have softened while home price

appreciation decelerated, which could hurt household net worth. Business capital

spending has cooled as well, while survey-based measures of planned spending

moderated, indicating investment will likely remain soft through the end of the

year. Tariffs and trade policy uncertainty seem to have put some firms' plans on

hold, anecdotal reports collected by the Fed show. 

     As rate hikes begin to bite, policymakers must assess whether indications

of weakness are just signs that the economy is shifting gears at a pivotal

moment. 

     And it may well be that the Fed's models show rate hikes and sectoral

rebalancing are working properly to avert excess price pressures -- and that

still a few more hikes are needed.

     --BALANCE SHEET

     Sources have told MNI that the FOMC will likely pick up where it left off

on discussions over whether to keep the floor system it has used to manage the

fed funds rate since the financial crisis or to go back to a system in which

bank reserves are scarce. 

     The decision is a critical one for how much further the Fed can shrink its

balance sheet. Officials have said the balance sheet will return to a size

that's no larger than needed for the central bank to implement monetary policy

efficiently and effectively within the chosen framework.

     Top officials appear to favor keeping the current system, sources said,

which would mean a larger balance sheet and perhaps an earlier end to the

balance sheet normalization program. 

     The chosen framework will also need to provide the Fed with effective

control over its benchmark short-term interest rate. The effective fed funds

rate has ticked steadily higher this year, threatening to breach the upper end

of the target range as the Fed continued to shed assets. 

     Simon Potter, chief of the trading desk at the New York Fed, in a recent

speech argued against the view that upward pressure on the fed funds rate

"signals that we've reached balance sheet normalization." 

     But how close the Fed is getting to that point will be up for discussion. 

--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com

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