Analysts with Morgan Stanley said Friday they expect the U.S. Federal Reserve to stop reinvestments of its mortgage-backed securities (MBS) holdings, in an effort to shrink its $4.2 trillion balance sheet caused by bond purchases made to battle the Great Recession.
The analysts based their predictions on the Fed’s projected 3 percent longer-run equilibrium interest rate, together with their own prediction of two rate hikes in 2017 and three in 2018.
Morgan Stanley issued a report detailing their forecasts early Friday morning.
"Applying this informal guidance to our expectation for the rates path leads us to believe the Fed will halt its reinvestments of MBS in April 2018," they said.
The analysts said they expect a “ramp-up” in messaging and an announcement in the March 2018 Federal Open Market Committee report.
The Fed's Treasuries and MBS holdings are about $2.46 trillion and $1.76 trillion, respectively. The Fed's balance sheet size is equivalent to about 22 percent of gross domestic product, according to the report.
"Ending Treasury reinvestments is not necessary for a gradual normalization of the balance sheet; the economy should grow into the Fed's Treasury portfolio within about a decade," they said.
They said in their FOMC preview that they expect the Fed’s “engine to idle” until September.
“Inflation expectations have tracked sideways, as has the trade-weighted US dollar,” the analysts said. “Incoming data continue to confirm an underlying pace of domestic economic growth around 2 percent.
“These factors combined suggest there isn’t much for the Fed to do at this meeting and it should deliver a positive sounding, but overall benign statement,” they said.
The analysts said minutes from the December FOMC meeting revealed discussions around possible upside risks to the outlook from fiscal policy, and several FOMC participants struck a more “upbeat tone” in recent statements.
“To the extent an even more upbeat tone emerges in the statement we could see current market derived probabilities for a March hike rise from approximately 30 percent today,” they said. “If done intentionally, then policymakers would like markets to give them more wiggle room on a possible March hike.”