Shrinking Fed Balance Sheet? Don't Sweat It!

USD  JPY Pushing Into Critical Resistance Alongside Correlated Markets

Shrinking Fed Balance Sheet? Don't Sweat It!

"Hurricanes Harvey, Irma and Maria have devastated many communities, inflicting severe hardship", Fed officials said in a policy statement Wednesday after their two-day meeting.

The Fed pursued three rounds of quantitative easing between 2008 and 2014 to stimulate the economy after the 2007-2009 financial crisis and recession. "So there's a little adjustment going on there", said David Joy, chief market strategist at Ameriprise Financial in Boston.

Fed officials cautioned that the devastation of Hurricanes Harvey, Irma and Maria would hold back the USA economy in the "near term". Economists had also forecast that Fed policy makers would maintain their projection for one more rate increase this year, and take that action in December.

Besides, and nearly unnoticed by markets, Fed balance sheet reduction has already and very gradually been taking place through U.S. commercial banks, which have reduced their excess reserves by roughly United States dollars 500 billion since 2014. With the Fed's shrinking balance sheet, a source of liquidity for markets will dry up, likely resulting in a small increase in interest rates.

Markets are now looking to the US Federal Reserve's (Fed) September policy meeting, scheduled for tomorrow and Wednesday.

In a statement following the Federal Open Market Committee's two-day meeting, central bankers pointed to signs of strength in the USA economy, including a pickup in household spending and growth in business investments. U.S. stocks remained flat.

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Despite many encouraging signs in the economy, Yellen is opting to go slowly to reduce the central bank's $4.5 trillion holdings.

Bond prices rose. The yield on the 10-year Treasury note fell to 2.24 percent. So far this week, U.S. assets have been popular due to expectations of a third rate hike this year in December and further rises into 2019. The Fed believes inflation will remain below the bank's 2 percent target until 2019.

In recent days‚ the local currency has come under renewed pressure as the dollar recovered because of improved perceptions that the US Fed could raise rates in December.

Minutes from the July meeting showed deepening worries about a prolonged period of low inflation. Quite simply, if Janet Yellen and the policymakers are positive and think a rate hike can occur this year, I would expect the Dollar to strengthen.

It has, however, left unchanged its growth forecast for next year (+2.1 per cent), as well as its projection of unemployment (at 4.3 %) and inflation (+1.6 percent) to 2017.

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