Fed Leaves Short-Term Rates Unchanged; Likely to Act Soon on Portfolio Cuts

By Nick TimiraosFeaturesDow Jones Newswires

WASHINGTON-The Federal Reserve signaled it could launch its plan to slowly shrink its large bond portfolio after officials' next meeting in September and held short-term interest rates steady.

In a statement Wednesday, the rate-setting Federal Open Market Committee said it expects to begin shrinking the bond holdings "relatively soon." Officials offered little indication that several weak inflation readings had altered its plans to raise interest rates once more this year.

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Fed officials voted unanimously to leave their benchmark rate in a range between 1% and 1.25%. They raised rates by one quarter percentage point in March and again in June, when they penciled in one more quarter-point moves this year. Many analysts expect that to occur in December, after the Fed initiates the gradual run-off of more than $4 trillion in mortgage and Treasury securities this fall.

Investors hadn't expected the Fed to raise rates Wednesday and were looking for signals about whether the slowdown in inflation this spring might alter the Fed's plans for another rate increase later this year. As of Wednesday morning, investors placed a roughly 8% probability of a rate increase in September and a 52% probability of at least one increase by December, according to CME Group.

The statement, released after a two-day policy meeting, noted the recent weakness in inflation but didn't deviate significantly from the statement released after last month's meeting. Inflation measures "have declined and are running below 2%," the new statement said Wednesday. It described job gains as "solid" and said household spending and business investment "continued to expand."

Fed officials completed and released their plans for the balance sheet after their June meeting, which pulled forward market expectations about when the central bank might set the wind-down strategy into motion. At the start of the year, investors expected that wasn't likely to occur until the end of this year, or in early 2018.

But with the plans now firmly in place-and with few signs of inflation pressures building despite low unemployment-officials have hinted they are ready to initiate the wind-down earlier and to defer another rate increase until later in the year, which would give them more time to assess inflation data. Fed Chairwoman Janet Yellen is scheduled to answer questions from the media at the September meeting, which would give her an opportunity to explain the committee's thinking if they announce the start date of the portfolio wind-down at that time.

Another opportunity for Ms. Yellen to elaborate on the Fed's plans could come at the end of next month, when the Fed leader traditionally speaks at an annual economic policy symposium in Jackson Hole, Wyo.

The economy has performed relatively in line with the Fed's expectations so far this year. Global growth has strengthened, while gross domestic product in the U.S. grew at an annual rate of 1.4% in the first quarter. The Commerce Department is set to report its initial estimate of growth during the second quarter on Friday, and economists polled by The Wall Street Journal expect growth for the quarter to rise to a 2.7% annual rate.

Solid earnings and brighter confidence measures have supported major stock indexes this year, and other asset prices, including housing, have advanced steadily higher. Financial conditions have eased despite three interest-rate increases by the Fed in the last three quarters.

Inflation has been the fly in the ointment for the central bank. The Fed's preferred measure of inflation declined in March from a month earlier after a drop in the prices of wireless phone plans. Inflation pressures have remained soft in the months since then, making it more difficult for Fed officials to dismiss the declines as resulting from one-off factors, as they did after meetings in May and June.

Excluding volatile food and energy categories, the Fed's preferred inflation gauge rose 1.4% from a year earlier in May, down from 1.8% in February.

Ms. Yellen told lawmakers earlier this month "there may be more going on" than a series of idiosyncratic price declines, but she also said it was "premature" to conclude underlying inflation was falling well short of the Fed's 2% target. "We have quite a tight labor market, and it continues to strengthen," she said.

The weakness on the inflation front is puzzling because unemployment has fallen to levels suggesting much less slack remains in the labor market, which Fed officials and many economists expect ultimately should force employers to boost wages and prices.

The Fed bought more than $4 trillion in Treasury and mortgage securities during and after the financial crisis to stimulate the economy by holding down long-term rates. Allowing the balance sheet to decline could cause long-term rates to rise.

The Fed stopped adding to its balance sheet in late 2014, but the central bank has been reinvesting the proceeds of maturing assets to keep the holdings steady.

Under the plan to reduce the portfolio, the Fed would set guardrails to allow a preset amount of holdings to mature every month without reinvestment. The guardrails would initially be set at a relatively low level-$10 billion a month-and they would increase every quarter by $10 billion up to a maximum of $50 billion.

Officials have said they want the plan to run quietly in the background once it starts. They have sought to avoid a prolonged market reaction to the start of the wind-down, such as the 2013 "taper tantrum" when investor concerns over the Fed's decision to slow down the pace of its asset purchases triggered market turmoil.

Markets haven't shown a significant reaction to the wind down plan so far. Economists say that partly reflects the relatively slow pace of the initial reductions and officials' indications the portfolio will decline to a final size that is relatively large compared to its precrisis level.

One potential complication for the Fed later this year will be a potential congressional standoff over raising the Treasury's borrowing limit. The Treasury Department has employed emergency cash-conservation steps that Secretary Steven Mnuchin said should last through September. After that, the U.S. risks being unable to make timely payments on government bills if Congress hasn't raised the debt ceiling, and the threat of default could roil financial markets.

(END) Dow Jones Newswires

July 26, 2017 14:15 ET (18:15 GMT)