More Rate Hikes in 2017, Unlikely

Bob Johnson: It's great to be here today.

Glaser: So, something like 95% probability there was going to be a rate hike today. You think they really had to deliver that no matter what the data really said?

Johnson: I absolutely believe so, because they were in a situation where they had many governors out talking about it, they had prepped the market for it. Now, if for some reason they didn't have one they'd say, "Uh-oh, what does the Fed see?" and everybody'd be running for the hills. The way they had set this up there, they couldn't hardly do anything but raise the rates today, and they did raise them a quarter of a point. So, they didn't do anything outstanding or go off the reservation, do a big number, but they did increase it and that's the fourth increase we've had so far. We're now in a fed funds rate range of 1 to 1.25%, so it's a bit higher than it was a couple of years ago.

Glaser: We also got a little bit more information on what a balance sheet normalization would look like. Anything that is interesting there to you?

Johnson: Yeah. First of all, let's talk a little bit about what that's all about. The balance sheet has clearly been an issue there, and it's been of great concern to a lot of people and a lot of our readers because the Fed has a balance sheet of about $4 trillion, the largest it's ever been in history, and it includes a variety of short-, and long-term, and mortgagelike securities. It's a huge balance sheet, and everybody's been wondering what the heck they're going to do about it. People are particularly fearful because the last time when they stopped buying any additional bonds we had the so-called taper tantrum, and we saw this giant back-up in rates and the market totally panicked, so they're really trying to manage expectations on that this time around, and I think they did a pretty good job of that.

Glaser: When would you expect them to really begin to start to reduce the size of the balance sheet?

Johnson: Yeah. I think they may start as early as the September meeting. I think they want to show people that we have a pathway, and that they want to move ahead. Given that I think the economy is slowing a bit, maybe they do the bond thing this time around, and don't raise rates one more time, but we'll have to see what they end up doing. They also did let us in on some of the mechanics. Again, I mentioned this is a $4 trillion balance sheet right now, and what they're proposing is to start out with not reinvesting the principal on the bonds that mature. They're talking about maybe 10 billion a month or 120 billion a year, so that's not a massive number relative to that $4 trillion portfolio.

On the other hand, their eventual goal was $50 billion a month, and that equates to $600 billion a month. Now, that will make a dent in that $4 trillion portfolio, and they want to leave something on the balance sheet--more than they've had in the past--so maybe they want to keep it--they didn't give a dollar amount--but I would guess maybe a trillion dollars might be a number to keep your eye on that they want to get it down to. Certainly, that seems like it's something that could happen over the next three or four years, but they're trying to do it in a gentle and focused way.

Glaser: There was a economic forecast released with the statement today. Any big changes in the way the Fed is thinking about the broader economy?

Johnson: Yeah. There are a few things that changed. First of all, GDP was actually revised just a little bit higher for this year to 2.2% from 2.1%. I think that was a mistake. I think things are actually slowing and not accelerating, so I was a bit surprised to see that, but they've made a big deal in the last announcement, they thought all the first quarter problems were transitory. I think this statement kind of drives that home that they really thought it was transitory. I think they're dead wrong on that. That was the biggest change.

They're still kind of 2.1% for the following year, and the long-term number remains at 1.8%. A lot of people think the Fed is kind of joking about that. That it's kind of low ball up number to justify everything that's going on, but no, I think that given the headwinds of demographics, I really think that's a real number, and that's what they really think. It's not some toy number that's out there that's way off base.

Glaser: You mentioned the possibility of the change of the balance sheet starting in September, but the dot plot which shows where the governors think rates will be seems to imply there's going to be another rate increase this year as well. Do you think that is plausible, or is the economy not going to be able to support that?

Johnson: My personal belief is we will not have another rate increase this year. I think that the economy is slowing on many sectors, and I think the ability of them to raise rates will be relatively limited. I don't know if it will be entirely clear by their next September meeting how much things have slowed, but I think it's more likely they'll begin on their balance sheet process rather than do an interest rate hike. If they do an interest rate hike--which I don't think they will--but it'd be more likely to me that it happens in December.

I do think they want to show people they're serious, that they've got a game plan, so we don't have another surprise like we did in 2013 with the taper tantrum, and I think they're really trying to avoid that. I think they've now set the stage where just like this time they almost had to raise rates even if the data was totally awful, and I think the same thing maybe true with the balance sheet in September. I think they'd like not to do both in the same month, so that they can see the impact, and so they don't have to guess which one did it.

Glaser: Let's look at the market reaction. The Fed operates in the short end to the yield curves or short-term rates. What's happening on longer rates?

Johnson: That's been a real mystery, or a surprise at least. Maybe not a total mystery, but since the end of the year the 10-year Treasury has gone from about 2.5% down to about 2.1, 2.2%. So, the number on the 10-year Treasury has actually come in which gets us back into the Greenspan-type of conundrum. They keep trying to signal and move the short-term rates up, but it's having almost the opposite effect on long-term rates, which is not great news in my opinion. When you've got that flattening yield curve it's going out put the banks back in some trouble again, and I think that's the last thing they need right in here.

Again, there's some artificial things. There's rumors of foreign buyers, especially Chinese buyers in our bond market, which was the problem in 2004, 2005, as well. You have fears about the various European elections that are going on. You've got geopolitical issues and the North Koreans. There's a lot of stuff out there, and there's a lot of people hitting the 10-year bonds as a safe haven. Maybe that's artificially depressing the rate a bit, but still it's not a great sign that they are continuing to raise fed funds rate, and the longer term rates are coming down. That's a prescription for disaster for banks.

Glaser: Overall then, no surprises from this report, but you have a different shaded view of the Fed over what's going to happen the rest of the year.

Johnson: Yeah. I really have thought for some time that the economy would be relatively weaker than expectations this year, and I have thought about 1.75 to 2%. Most of the forecasts were more up toward 2.5% at the beginning of the year. More have come my way, but I still think this isn't going to be a year of great growth. A lot of things that have been key drivers of the economy--aerospace, autos, oil production, equipment related to oil production--have all been big factors in economic growth, along with health care and restaurant meals. And every one of those categories is showing some signs of weakness.

There just isn't a lot to replace it. Maybe it's in computers here and there. That sector's been strong. Grocery store food production has also been relatively strong. Those are two bright spots, but I don't think either one of those is big enough to offset the five categories I mentioned that are weakening.

Glaser: Bob, thanks for sharing your thoughts today.

Johnson: Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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