December Fed meeting: Glass now half-empty?
Recent positive vaccine news has boosted the likelihood of a strong recovery, but virus seasonality suggests the worst may still lie ahead.
As always with this pandemic, a lot changes in a short period of time. The vaccine moment from last week is now battling with more immediate concerns around the increasing number of hospitalisations in the US. Many observers now believe it’s possible that statewide lockdowns will be enacted around the end of November and Thanksgiving which takes place next Thursday.
FOMC lacking FOMO
The previous Federal Reserve meeting in September saw no changes in monetary policy with a clear message to ‘keep calm and carry on’. The FOMC said it would not hike rates until 2024 at the earliest, but didn't increase its QE buying pace and so was not as supportive for the recovery as it could have been. Markets initially cheered, but this was later reversed with 10-year breakeven inflation rates ending the day marginally below where they were before the announcement.
The Fed had a good opportunity to show its determination in creating inflation and achieving its new goal by increasing the pace of its bond buying at this meeting. And given low inflation expectations in the market and also among board governors in Washington, it seemed strange that the Fed didn’t think further easing was necessary. Lessons from history and research show that monetary policy is most effective if it’s fast and powerful. Instead Chair Powell, perhaps due to differing views of the committee, didn’t seem in a hurry at all to move the easing dial.
Worries now materialising
That luxury of time seems to be rapidly disappearing now, even though the economy just recorded a 33.1% annualised GDP gain in the third quarter and the country is in the middle of a housing boom. Since the expiration of the main provisions of the $2.2 trillion CARES Act, the huge tailwind that had been driving consumers has dried up and the delay and wrangling over the next fiscal package will inevitably hurt the economy. With 22 million jobs lost since the start of the pandemic, there are still over 10 million left to recover, with recent job gains stalling recently.
Inflation expectations have also edged lower even since the Fed approved its policy to let inflation run above its 2% goal after periods where it has fallen below that level. Previously, the board of governors would have used falling unemployment as a pre-emptive signal to move policy and raise rates to curb inflation. The Fed’s preferred gauge still remains well below the central bank’s desired 2% target, a flexible average, at 1.5% in the 12 months through September.
What weapons are left in the arsenal?
It seems clear that Fed members, both hawks and doves, will be clamouring explicitly for fiscal policymakers to do more in the run-up to its December meeting. Lael Brainard, strong favourite to be the next Treasury Secretary under President Biden, recently said that the failure of Congress to come through represents “the most significant downside risk” to her economic forecasts. But it seems fiscal stimulus is caught up in the Washington election aftermath of a partisan, lame duck Congress.
The central bank has continued to offer help to Main Street through its various lending programs and won't be raising short-term rates for years. But the Fed’s new average inflation targeting policy regime does have limitations in the current environment as it's much more powerful under positive shocks moving deeper into expansion.
The most likely Fed response would be to adjust the composition or pace of asset purchases to achieve various ends, for example, it could extend the duration of the bonds to influence yields further out the curve. However, officials have expressed only lukewarm support for such a move because they see it as unlikely to be particularly effective. Notably, asset purchases have tailed off substantially lately, with the last four months seeing the Fed’s balance sheet grow by just 1.3% compared to the 66% explosion in the March to June period when the pandemic began.
If spreads between yields start to widen, some form of yield curve control through purchases could be adopted, which would reinforce forward guidance. Indeed, Brainard has forewarned markets of using tools like this already. Finally, the Fed could continue to alter the language it uses to frame the goals of the purchases, from enabling market functioning to broader support of the economy.
Light at the end of the tunnel
On the flip side, if markets do start to price in a medium-term recovery before the Fed is comfortably satisfied with the inflation outlook, like we saw with curve-steepening on the back of the vaccine news, de facto curve control may be a policy option. Operation Twist for example, when the Fed bought long-term bonds from sales in short-term bills, which didn’t expand its balance sheet, was used previously in 2011.
One fundamental issue to bear in mind is the political battle that will play out in the state of Georgia in early January which could lead to the Democrats taking control of the Senate. If they do succeed, the chances of a multi-trillion dollar fiscal stimulus package increases, which would turn the lower-for-longer market mindset on its head.