When Federal Reserve officials conclude their two-day policy meeting on Wednesday, they may at last have succeeded in divorcing the actions they take in managing the U.S. central bank's massive balance sheet from interest rate decisions.
That would be a stark contrast from a year ago, when Fed Chair Jerome Powell's comments that the balance sheet reduction was on "autopilot" gave investors the impression the central bank was on a strict course of tightening monetary policy, with no flexibility to tackle concerns about market liquidity or slowing global growth.
Since then, the Fed has shifted course, both on policy and in its messaging.
It moved from raising rates to cutting them. Officials moved from shrinking the balance sheet by $50 billion a month, which was viewed as an action to tighten policy, to growing it by $60 billion a month. And they did so with a strong message that the purchases of short-term bills are not intended to "have any meaningful effects" on the economy. The balance sheet now stands at nearly $4 trillion.
Investors waiting for updates from the Fed on Wednesday are now free to focus on what is usually the main attraction of the policy meeting: the direction of interest rates.
The Fed's policy-setting committee is largely expected to announce a quarter-percentage-point cut to the central bank's overnight benchmark lending rate when it releases its latest policy statement at 2 p.m. EDT (1800 GMT). Powell will hold a news conference to elaborate on the decision half an hour later.
A rate cut would be the third this year, bringing the policy rate to a target range of 1.50% to 1.75%. Investors will also be tuning in for clues as to whether policymakers feel like they have acted appropriately to address the potential headwinds to the U.S. economy or if more easing is needed.
Some economists say the efforts to separate the discussion about the balance sheet from the question of monetary policy appear to be working.
"I do think the two issues are separate, and they have and will continue to try and reinforce that," said Karim Basta, chief economist for III Capital Management. "My main interest at the next meeting is more on the interest rate policy and how they might characterize the risks."
The Fed's messaging is intentional. In its response to the last recession, it paired its massive purchases of Treasury bonds and mortgage-backed securities with clear forward guidance that the goal was to lower long-term rates and stimulate the economy.
This time, officials are calling the purchases a "technical adjustment" and have couched nearly every mention of the initiative with a reminder: This is not quantitative easing.
"The Fed's toolbox isn't just increasing or lowering the federal funds rate - it's also how they communicate with markets," said Nela Richardson, an investment strategist with Edward Jones. "Words matter."
NOT SO EASY
The balance sheet expansion program announced in mid-October is part of a concerted effort by the Fed to avoid a repeat of the liquidity crunch in mid-September that led to a spike in short-term borrowing rates. The Treasury purchases, combined with daily repo operations, are meant to resolve the liquidity issues so that they do not get in the way of the Fed's main job of setting monetary policy.
But some investors say it's not so easy to completely isolate those large asset purchases.
"They are trying to send the signal to everyone else to think about them as separate," said Lewis Alexander, chief U.S. economist at Nomura. "I frankly have a problem with that."
Alexander said he would like more clarity on how the Fed decides which assets it is going to buy when managing its balance sheet. "I just don't understand how they're thinking about this decision," he said.
The Fed's efforts to improve liquidity in financial markets could stimulate the economy by boosting investors' outlook, said Julian Emanuel, chief equity and derivatives strategist for BTIG. Some financial firms may feel more comfortable with making investments if they believe markets are operating smoothly, he said.
By snapping up short-term Treasury bills, the Fed also helped to reverse the so-called inverted yield curve, which happens when the yields on long-term bonds fall below those on short-term bonds. The pattern is typically viewed as a red flag for the economy because it has preceded every recession since the late 1950s. Some people might take the recent steepening as a sign that recession risks are diminishing, Emanuel said.
Concerns, however, remain about the central bank's plan to ensure that money markets run smoothly through the end of the year and beyond.
For example, some investors will want to know how much officials discussed the possible creation of a standing repo facility, said James McCann, senior global economist at Aberdeen Standard Investments.
The Fed calmed money markets in mid-September by injecting cash into the overnight borrowing markets for cash, operations that will continue into next year. But some investors say they still have questions about what caused the volatility.
"It does not engender confidence," said Quincy Krosby, chief market strategist for Prudential Financial. "The problem may be more systemic than what the Fed is suggesting."
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