As all eyes watch the Fed and their decision to raise rates or not most of us look at the factors that influence inflation. Inflation has been cited as the foremost index that the Fed wants to manage through monetary policy. Inflation measured by the Consumer Price Index (CPI) rose 2.1 percent in 2016, a larger increase than the 0.8 percent rise in 2014 and the 0.7 percent advance in 2015. The 2.1 percent is greater than the 1.8 percent average increase over the past 10 years. The combination of CPI at 2.1 percent (1.5 percent greater than 2015) and the pro-business platform of the new administration has the Fed closely watching the market and broadcasting to the marketplace that short-term interest rates are going to move higher in 2016. This dialogue is what we we’ve known for awhile. What the Fed hasn’t been telling us is this.
In 2008, as the market was melting down, several steps were taken to stabilize the market. One of the steps the Fed took was to purchase fixed-income assets, especially on the long end. This action by the Fed helped to rebalance supply and demand and create a price floor allowing the market to begin healing. Prior to 2008, the Fed’s balance sheet for these type of assets was $1 trillion. Currently, the Fed’s balance sheet is $4.5 trillion or 350% higher pre-crisis.
Rolling the video forward to 2017, the economy is doing well and the safeguards in place should allow it to continue to grow for some time ahead. With that said, the Fed is now thinking about shrinking their balance sheet to pre-crisis level which in simple terms would have them selling some or all of the $3.5 trillion of debt back into the market place. The shrinking of the balance sheet is going to influence asset prices and correspondingly asset yields. Clearly supply and demand will be affected by the liquidation and the influence should put pressure on rates to rise.
This is another external pressure on rates and is additive to the Fed meeting in March which should result in another 25 basis point move. Although a bit redundant at this point, rates remain a bargain at these levels which may not be the case a year from now.