The Federal Reserve is about to hold its second Federal Open Market Committee (FOMC) meeting under its new monetary policy framework amid strange and rapidly changing circumstances.
No policy change is likely on November 5. In other words, the FOMC will almost certainly leave the federal funds rate in the zero to 25 basis point target range that it has been in since March. And it will most likely pledge to continue increasing its holdings of Treasury securities and agency mortgage-backed securities “at least at the current pace” of $120 billion per month “to sustain smooth market functioning and help foster accommodative financial conditions, thereby supporting the flow of credit to households and businesses”.
One thing to look for, if not at the upcoming meeting, then at a subsequent one, is an application of outcome-based “forward guidance” to asset purchases (quantitative easing).
Fed Governor Lael Brainard recently said that, “In the months ahead we will have the opportunity to deliberate and to clarify how the asset purchase program could best work in combination with forward guidance to support achievement of maximum employment and per cent inflation.”
Other officials have also privately hinted the FOMC will eventually condition asset purchases on inflation and employment outcomes.
But it may be too early for that.
The FOMC doesn’t have to produce revised economic and rate projections this time, but participants will nonetheless be taking stock of the economy and its outlook, as is perfunctory. They will also consider financial conditions as they reassess the Fed’s ultra-easy credit stance in this extraordinary environment.
Complicating their job are ramifications of the global coronavirus epidemic and an unusually divisive general election.
Chairman Jerome Powell and his colleagues will be confronting an economy still struggling to recover from lockdowns ordered to contain the virus, some of which remain quite draconian in states comprising a large proportion of GDP.
As Covid cases have mounted in the US and around the world, fear of further lockdowns and consequent blows to output and employment have caused financial market jitters, even though death rates remain very low. A vaccine is said to be at hand, but until it actually starts being administered on a large scale the virus will continue to cast a dark cloud over the economy.
Third quarter US GDP came in at a record 33.1% increase Thursday yet the level is still 2.9% below a year earlier. Beyond the third quarter, the prognosis is as uncertain as the virus itself, partially because the governmental response is up in the air during this tense election season.
So far, consumer spending has held up well, and there has been strength in housing, but there have been signs of a faltering recovery in the labour market and elsewhere. The “beige book” survey of economic conditions in the Fed’s 12 districts, prepared for the November 4-5 FOMC meeting, describes recent growth as just “slight to modest”.
Additional fiscal stimulus has so far not been forthcoming, with negotiations between Republicans and Democrats stymied as the election approaches.
The election, results of which may not be known with finality for weeks or even months, also cast doubt on future federal tax, regulatory, trade and other policies.
It’s been truly remarkable to watch Powell and his lieutenants wade waist deep into fiscal policy. Fed policymakers have traditionally been shy about inserting themselves into that realm, preferring to “stick to their (monetary) knitting”. But increasingly Powell has sold out for aggressive fiscal stimulus in a way no Fed chairman has ever done before.
Speaking to the National Association for Business Economics earlier in October, the Fed chief acknowledged the federal budget is “on an unsustainable path”, but added “this is not the time to give priority to those concerns”.
“It is likely that more fiscal support will be needed,” Powell said, adding, “Even if policy actions ultimately prove to be greater than needed, they will not go to waste. The recovery will be stronger and move faster if monetary policy and fiscal policy continue to work side-by-side to provide support to the economy until it is clearly out of the woods.”
Powell was echoed by Vice Chairman Richard Clarida and others.
“Continued targeted support to replace lost incomes will be an important factor in determining the strength of the recovery,” Brainard declared.
“Apart from the course of the virus itself, the most significant downside risk to my outlook would be the failure of additional fiscal support to materialise,” she continued. “Too little support would lead to a slower and weaker recovery. Premature withdrawal of fiscal support would risk allowing recessionary dynamics to become entrenched, holding back employment and spending, increasing scarring from extended unemployment spells, leading more businesses to shutter and ultimately harming productive capacity.”
In making a cautiously optimistic forecast, Chicago Fed President Charles Evans quickly attached the caveat that it “assumes that additional federal fiscal policy actions are coming…Without adequate fiscal support before too long, I am concerned that recessionary dynamics will gain more traction and lead to a slower trajectory back to maximum employment.”
What makes these pleas for debt-funded federal spending all the more remarkable is that $3 trillion has been expended since March on top of the deficit spending that was already in progress before the Covid invasion. The federal deficit has ballooned to a record $3.1 trillion in fiscal 2020, pushing the debt to GDP ratio to 102%.
But maybe we shouldn’t be too surprised, given the constraints on the central bank’s ability to promote recovery. Powell and others insist they still have plenty of monetary ammunition. But the reality is that, with the funds rate already near zero and with its balance sheet already bloated, the Fed has quite limited leeway.
Former New York Fed President William Dudley said, “The efficacy of monetary policy is rapidly diminishing.”
“We’re already seeing the interest-sensitive sectors of the economy doing fine,” Dudley said. “So if the Fed did more, what would be the effect on the economic trajectory? It would be very, very modest.”
Overcompensating for its limitations, the Fed is brazenly advertising its intention to hold the funds rate near zero indefinitely.
At its September 15-16 meeting, FOMC participants projected a zero-to-25 basis point target range through at least 2023, but Philadelphia Fed President Patrick Harker may have synthesised Fed sentiment more revealingly when he said he and his colleagues intend to “keep those rates very low for a very long time”.
More important than the funds rate “dots” is the way the FOMC activated the “August Statement on Longer-Run Goals and Monetary Policy Strategy” on Sept. 16.
The FOMC let it be known that, henceforth, it “will aim to achieve inflation moderately above 2% for some time so that inflation averages 2% over time and longer-term inflation expectations remain well anchored at 2%” and will “maintain an accommodative stance of monetary policy until these outcomes are achieved”.
Just as importantly, the FOMC said it “expects it will be appropriate” to keep the funds rate near zero “until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2% and is on track to moderately exceed 2% for some time.”
As Clarida explained, “This language means that going forward, a low unemployment rate, in and of itself, will not be sufficient to trigger a tightening of monetary policy absent any evidence from other indicators that inflation is at risk of moving above mandate-consistent levels.”
So far there is substantial consensus among Fed policymakers, but it’s not monolithic. In September, there were two dissenters. Dallas Fed President Robert Kaplan agreed it was appropriate to keep the funds rate near zero “until the Committee is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals…,” but wanted the FOMC to “retain greater policy rate flexibility beyond that point”.
Minneapolis Fed President Neel Kashkari, by contrast, wanted the FOMC to “indicate that it expects to maintain the current target range until core inflation has reached 2% on a sustained basis.”
And other fissures could emerge. One could be differences over the extent to which financial stability concerns figure into future monetary policy decisions.
The Fed leadership hasn’t had a lot to say about the potential for persistently low interest rates to distort financial market valuations, incentivise excess risk-taking and create imbalances. But increasingly we are hearing voices of caution.
Cleveland Fed President Loretta Mester, a 2020 FOMC voter, warned on October 21 that “in an environment with low neutral rates, a persistently accommodative monetary policy could, in some cases, increase the vulnerabilities of the financial system by encouraging higher levels of borrowing and financial leverage, increased valuation pressures, and search-for-yield behavior”.
“How best to approach the nexus between monetary policy and financial stability in a low interest rate world deserves more consideration,” she added.
Mester noted that most Fed officials believe “supervisory, regulatory, and macroprudential tools, including the countercyclical capital buffer and stress tests, should be the primary way to address financial stability risks rather than using monetary policy”.
However, she added, “There are few countercyclical tools and they are not designed to address vulnerabilities outside of the banking system. Therefore, there may be certain circumstances where monetary policy may need to be adjusted in order to mitigate risks to financial stability.”
Similarly, Boston Fed President Eric Rosengren has cautioned, ”If we expect to remain in a low interest rate environment for a protracted period of time, we need to take more precautions against financial stability risks for when the next economic shock hits.”
It is not hard to imagine circumstances in which financial market developments, be they in the equity market, the money market, the bond markets or the foreign exchange market, could impinge on monetary policy deliberations. Problem areas have a way of turning up in unexpected areas, despite the Fed’s best efforts to anticipate them.
For now, though, and for the foreseeable future, it is hard to envision a shift toward monetary firming or normalisation.
The unusual amount of political uncertainty attending this fall’s general election will hopefully be resolved one way or another fairly soon, yielding greater predictability in a host of policy areas.
More worrisome perhaps is the coronavirus. Certainly that’s what’s been uppermost in the minds of Fed officials. As the FOMC said on September 16, “The path of the economy will depend significantly on the course of the virus. The ongoing public health crisis will continue to weigh on economic activity, employment, and inflation in the near term, and poses considerable risks to the economic outlook over the medium term.”
That sentiment has been echoed many times since then.
“In thinking about the future path of policy, it is important to recognise that the pandemic engenders a unique and highly uncertain economic outlook,” said New York Fed President John Williams. “This is not a standard recession and the economic future is inextricably tied to the spread of the virus, people’s behaviour in containing that spread and the development of vaccines and therapeutics.”
What remains to be seen is how quick the FOMC will be to respond to the economic improvement that will come sooner or late as and when the virus is defeated or at least brought under control.
How long will the Fed stay at zero? When will it stop expanding its balance sheet or, at least, start tapering the pace of asset purchases?
There are too many contingencies to say for sure.
Addressing the question of the timing of “lift off” on October 20, Brainard said, “It is difficult to anticipate how long it will take to achieve the conditions set out in the forward guidance…”
“When it does lift off, the policy rate could be expected to change only gradually, reflecting the commitment to remain accommodative until inflation has moderately exceeded 2% for some time,” she went on. “Of course, the pace of the recovery will dictate the actual path of monetary policy, as implied by the conditional outcome-based forward guidance adopted in September.”
Over time the economic picture will clarify and policymakers’ comprehension will evolve – or perhaps financial markets will force their views to change – but for the foreseeable future the Fed majority seems determined to lock monetary policy into an unprecedentedly expansionary partnership with fiscal policy.