The Fed’s decision day is finally here. We’ll review the new information we received on Wednesday from the Fed in this article. The headline wasn’t a surprise as the Fed didn’t raise rates and it said the $10 billion per month unwind will start in October. The new information we got on the unwind is that in October 2018, the unwind will hit its peak of $50 billion per month. The Fed still hasn’t given guidance on what the balance sheet will look like when the unwind stops. The chart below shows the expected changes in central bank liquidity over the next two years. As you can see, the ECB and the Fed are about to change their policies, pushing down the net change in liquidity to near zero.

The fact that the Fed didn’t tell us what the size of the balance sheet will be by the end of this unwind isn’t a surprise because the Fed only gives interest rate guidance up until 2019. That means if the unwind was going to end in 2019, it would tell us. The unwind is expected to end around 2020, so there’s time before a policy decision is given. The Fed said the unwind will be like watching paint dry, but we all know this situation is more complex than that. This is why why the Fed didn’t tell us what the end goal of the unwind is. It will probably depend on the economy in the next few years. If the economy is strong in 2018 and 2019, the Fed might bring the balance sheet down toward $2 trillion. If the economy weakens in 2018 and 2019, then it might end the unwind closer to $3 trillion. If there’s a recession, the Fed will probably end the unwind early and possibly start another round of QE.

The guidance on the unwind has been relatively stable recently as I have been able to predict it would start in October for the past few months. That’s been under a scenario where growth and inflation have stayed near forecasts and the stock market has risen consistently without any volatility. We’ve seen changes to rate hike guidance in response to volatility in 2015 and 2016, so I’d expect the guidance on the balance sheet to be no different. I expect that if Q1 2018 economic data is weak and the stock market sells off 5% or more, the Fed will probably push the goal of the unwind reaching $50 billion per month back to 2019. It’s important to recognize how lucky the Fed is that stocks haven’t sold off 3% this year yet. While there’s no certainty when this calm period will end, the idea that it will continue until October 2018 seems like an impossibility.

Now let’s look through some of the specific forecasts and guidance. The most pressing issue, now that the balance sheet guidance has been provided for the rest of this year, is what the Fed will do with interest rates. Twelve of the 16 FOMC members said they expect one more rate hike this year. This perfectly aligns with the new way the market has been pricing in the chances of a hike this year. After the FOMC decision, the chances of a rate hike in December inched up slightly, passing the 70% threshold necessary for a hike. There is now a 73.4% chance at least one hike occurs by December.

The current Fed forecast shows there will be three rate hikes in 2018 and two hikes in 2019. In this case, when you look at rate hikes combined with the changes in the balance sheet, both years will be similar. 2019 will have more of an unwind, assuming it doesn’t stop that year, and 2018 will have one more rate hike. The FOMC now sees 2017 GDP growth to be 2.2% which is one tenth of a percent higher than the prediction made in June as there’s no negative effect from the hurricanes baked in. The Fed also reduced its inflation forecast from 1.7% to 1.5%. It’s interesting to see how its rate decisions and balance sheet decisions weren’t impacted by this change in inflation. It shows how the Fed is willing to follow the stock market and act hawkishly when there’s no volatility. The Fed also lowered its inflation forecast from 2% to 1.9% in 2018. Considering the fact that the last CPI report beat expectations, the lowering inflation forecast shows how delayed it is in relation to the latest economic reports. It changed its forecasts based on the weak inflation in Q2.

Finally, the Fed lowered its long term Fed funds rate target to 2.8% from 3.0%. That’s below the 2019 projection, implying the Fed will end its rate hikes in 2019. This is interesting because sometime between 2019 and 2020, the ECB will start its rate hikes assuming everything goes according to plan.

The stock market rallied moderately in response to this decision as the Dow and the S&P 500 notched another record high. The Russell 2000 rallied 0.35%; it’s now 5 points off its all-time high. Nothing the Fed did was that surprising, so maybe the market was satisfied with the lack of a negative surprise. The 30-year bond rallied slightly to 2.8081%. The 10-year bond sold off to 2.2676%. The two year bond sold off sharply to 1.4382%. That makes the difference between the 10 year and the two year 82.94 basis points. That signals to me the economy is on solid footing. There’s no forecast for a recession in 2018.

Conclusion

The Fed was moderately dovish when describing rate hikes and a potential unwind as it likely gained confidence from the recent CPI beat, the fact that the government raised the debt ceiling, and the fact that stocks are rising practically everyday. The stock market took this news in stride as it makes a run at the longest streak without a 3% correction ever.