A commitment to easy money
Dr. David Kelly
As was widely anticipated, the Federal Open Market Committee (FOMC) voted to maintain the current Federal funds target rate at a range of 0.00%–0.25% at the September meeting. In addition, the committee will maintain its current pace of U.S. Treasury and agency mortgage backed security (MBS) purchases at roughly 80billion USD (gross) and 40billion USD (net) per month, respectively.
Today’s meeting was the first in which the FOMC, after officially updating its Statement on Longer-Run Goals and Monetary Policy Framework, was guided by its new average inflation targeting framework. This was clearly reflected in the statement itself. Importantly, the Federal Reserve (Fed) explicitly stated two conditions that would need to be met in order for the Committee to consider an adjustment to policy rates: 1) inflation would need to run moderately above 2% for a period of time to compensate for periods of low inflation, and 2) longer-term inflation expectations would need to remain anchored at 2%. While this isn’t new information, it further reinforces the tying together of short-term rates and inflation outcomes, and lays the groundwork for further rules-based guidance at the December meeting (although Fed Chairman Jerome Powell downplayed this somewhat during the press conference).
Moreover, even after strong job gains and an uptick in economic activity during recent months, the Committee acknowledged that labor markets are still far from pre-pandemic levels, and therefore will continue to use its policy tools to ensure maximum employment. However, while employment conditions remain a focus for the Fed, it does appear to be secondary to inflation outcomes.
In addition, the FOMC updated its Summary of Economic Projections (SEP) and interest rate projections (“dot plot”) out to 2023. Relative to its June estimates, real GDP was upgraded from -6.5% to -3.7% year-over-year in the fourth quarter of 2020, reflecting expectations for a strong bounce back in economic activity during the third quarter. Its forecasts of the unemployment rate were revised significantly lower to 7.6% and 5.5% for the fourth quarters of 2020 and 2021, respectively, signaling the expectation that the strong gains seen in the labor market will carry through into 2022. Meanwhile, both core and headline personal consumption expenditures inflation are expected to trend towards 2% through the forecast period, and while estimates were revised higher relative to June, they continue to fall short of the Fed’s 2% target. Lastly, the median federal funds rate projection—as measured by the “dot plot”—implies no rate adjustments for the remainder of this year and next. One committee member voted for higher rates in 2022 and four members elected for higher rates in 2023.
In considering the Fed’s outlook, it is difficult to see an environment in which the unemployment rate falls by roughly a full percentage point each year through 2023 and economic growth runs well above the Committee’s long-run estimate, but inflation persistently undershoots its 2% target. To achieve its goal, if inflation averages roughly 1.8% over the forecast period, it would need to average 2.2% in the middle of the decade before rates are adjusted meaningfully higher. While this reinforces an accommodative policy stance for the foreseeable future, it suggests the missing link for inflation continues to on the fiscal side.
That being said, fiscal policy is likely to be highly stimulative in the event of a Republican or Democratic sweep. Under a divided Congress, stimulus measures may be more difficult to pass and therefore may be smaller in scale. Still, the fiscal impulse of expanding deficits in 2021 could cause significantly higher inflationary pressures throughout the economy. This, in turn, could push inflation meaningfully higher in 2H21, potentially forcing the Fed’s hand in raising interest rates well ahead of expectations and creating a significant risk for fixed income investors.
The Fed continues to signal a commitment to accommodative policy through the Summary of Economic Projections, dot plot and forward guidance. An easy Fed should continue to support risk assets while keeping short-term rates pinned at zero. Long-rates may grind higher as the economy gradually recovers, suggesting a steeper curve in the months ahead, but there are limits to how high rates will rise as long as service sector activity remains muted.