Fed fleshes out new monetary policy — to mixed reviews

The Federal Reserve has often said it would keep monetary policy loose for years to come in response to the coronavirus pandemic. On Wednesday, it tried to flesh out what that would mean in practice — and received mixed reviews.

The US central bank said interest rates would not rise in the world’s largest economy until it reaches full employment and inflation hits 2 per cent and remains on track to “moderately exceed” that target “for some time”.

The guidance reflected the Fed’s announcement last month of a new long-term monetary policy that abandoned pre-emptive rate rises to stymie inflation, and was touted by Jay Powell, Fed chair, as an additional step to boost the economic recovery from the coronavirus shock

“I would say this very strong, very powerful guidance shows both our confidence and our determination,” he told reporters after a meeting of the Federal Open Market Committee. “It shows our confidence that we can reach this goal and our determination to do so.”

The move did reinforce the Fed’s dovishness. But some economists and investors doubted whether the more specific guidance would be effective in achieving the central bank’s ambitious economic objectives, leaving it under pressure to deploy other more aggressive tools to help the recovery.

“There is all this talk about not hiking rates until inflation is [averaging] 2 per cent, but they haven’t been able to create inflation . . . on a consistent basis for a very long time,” said John O’Connell, a portfolio manager at Garda Capital Partners. “From a credibility perspective, it remains to be seen.”

The Fed’s own projections suggest the more specific forward guidance may not be sufficient to meet its targets — at least not any time soon.

According to the median forecast of Fed policymakers published on Wednesday, core PCE inflation — its preferred measure — will remain below 2 per cent until 2023, with no period of overshooting that target. The 10-year break-even rate — which serves as a proxy for investors’ inflation expectations — still hovers well below that threshold, at 1.68 per cent.

“The messaging is tough,” said Mr O’Connell. “If it is going to take that long to get inflation, why not do more from a policy standpoint now?”

Some economists said the move to inflation-based forward guidance was more about laying out a more specific path for policy, rather than an urgent need to ease monetary conditions now. 

“I wouldn’t view it as an easing step,” said Jan Hatzius, chief economist at Goldman Sachs. “I would view it as delivering on something that was already pretty widely expected, which is a much more dovish framework. Will it be sufficient? That will depend on the economy.”

Robert Rosener, senior US economist at Morgan Stanley, said: “It gives confidence that you have a Fed that’s going to be leaning into the recovery, that’s going to be allowing momentum to build and allowing inflationary pressures to build without raising rates. That can have a pretty profound effect on interest rate expectations, and investment and consumption planning.” 

Some market participants had expected the Fed would announce adjustments to its $120bn monthly bond-buying programme, which involves the purchase of $80bn of Treasury securities and $40bn of agency mortgage-backed securities.

But the Fed did not boost the scale of its programme nor tweak which securities it would buy. When asked about the prospects of the Fed soon making those adjustments, Mr Powell did not indicate an urgency to do so.

Longer-dated Treasury securities sold off as Mr Powell fielded questions, reflecting what some strategists saw in part as disappointment about the Fed’s stance. Mike Collins, senior portfolio manager at PGIM Fixed Income, said Mr Powell needed to send a stronger signal about the other policy tools the Fed would be willing to use.

“In order to get growth back to 2 per cent on a sustained basis and inflation back above 2 per cent with limited fiscal dry powder, the Fed has to do a lot more heavy lifting than they are doing now,” he said.

The Fed may have to deploy more firepower in the future. It has acknowledged that the US recovery remains fragile — dependent on continued fiscal support, which is elusive, and consistent improvement in dealing with the pandemic, which is questionable. Mr Powell is also very worried about long-term damage to the fabric of the economy.

“The current economic downturn is the most severe in our lifetimes,” he said. “It will take a while to get back to the levels of economic activity and employment that prevailed at the beginning of this year, and it may take continued support from both monetary and fiscal policy to achieve that.”

So far, the pace of the rebound has exceeded the Fed’s expectations, reducing pressure on the central bank to be more aggressive. Its officials projected that output would contract by 3.7 per cent this year, compared with a decline of 6.5 per cent expected in June.

Mr Powell also had to balance a hawkish dissent to the statement, from Robert Kaplan, president of the Dallas Fed, and a dovish dissent from Neel Kashkari, president of the Minneapolis Fed, suggesting some disagreement coming to the fore about how to handle the next stage of the crisis.

Even so, Mr Powell said the central bank still had room to act, if necessary.

“I certainly wouldn’t say that we’re out of ammo. Not at all,” he said. “We do have lots of tools. We’ve got the lending tools. We’ve got the balance sheet. We’ve got further forward guidance. There’s still plenty more that we can do.”

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