–Fed Officials Agree in Principle; Only Time Will Tell On Implementation
By Steve Beckner
(MaceNews) – Important questions but only tentative answers abound as the Federal Reserve approaches its first monetary policy meeting of the new year in a mood to await further economic, financial and, yes, public health developments before changing its policy settings.
After two weeks of intense live-streaming what can we conclude about Fed officials’ perspectives and intentions going into their Jan. 26-27 Federal Open Market Committee discussions?
There is not complete unanimity, and views could diverge as events unfold, but for now there is consensus on some key points.
First, officials are generally optimistic about the economic outlook as the Covid vaccine becomes more widely administered. However, they remain wary of downside risks and emphasize extraordinary “uncertainty.” They believe it will take a long time to return to full employment, perhaps even longer to achieve the FOMC’s 2% inflation goal.
Second, officials concur on a revised set of objectives with far-reaching policy implications.
The Fed has a “dual mandate” to pursue “maximum employment” and “price stability, but when it revised its long-term monetary policy strategy or “framework” last August and changed its “forward guidance” in September and December, it redefined that mandate in significant ways.
In keeping with the new “framework” officials are committed to getting inflation not just up to the 2% target, but “moderately” above it “for some time,” along with “maximum employment.”
They now see maximum employment as a more “broad and inclusive” measure that takes into consideration more labor market indicators. And, unlike the past, the Fed will not raise interest rates preemptively when unemployment goes below some theoretical “natural” rate or NAIRU (non-accelerating inflation rate of unemployment). Officials now believe there is little, if any, Phillips Curve trade-off between unemployment and inflation, hence no need to fear “overheating.”
As for “price stability,” the FOMC is actively seeking to overshoot its inflation target for an indefinite period to compensate for previous years of undershooting.
As the FOMC reiterated Dec. 16, “With inflation running persistently below this longer run goal, the Committee 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%.”
Third, officials are putting more emphasis than ever on “anchoring” inflation expectations at least at 2%. Accordingly, they welcome the recent uptrend in expectations.
Fourth, it follows that officials are prepared to keep the federal funds rate near zero for the next several years. Even after the economy returns to ostensible “full employment,” they will hold rates down so long as inflation has not overshot 2% long enough to make up for past undershooting to reach a 2% average.
As the FOMC reiterated, in keeping the federal funds rate at zero to 25 basis points on Dec. 16, it “expects it will be appropriate to maintain this target range 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.”
Fifth, even after “liftoff” from the zero lower bound, officials plan to maintain a very loose monetary policy. Rates will rise only gradually and remain relatively low.
Sixth, liftoff will only occur after the Fed has ceased or at least tapered asset purchases.
Seventh, although some have spoken of “recalibrating” asset purchases, there is little inclination to reduce the pace of purchases from the current $120 billion per month until next year.
In fact, there would probably be more support for increasing purchases than reducing them for the foreseeable future. The first option, however, might be to increase the average maturity of Treasury purchases.
The longer the FOMC delays tapering, the longer it will delay liftoff.
Eighth, Fed officials enthusiastically favor ongoing “fiscal support” at a time when the incoming Biden administration and Democratic Congress are planning even more deficit spending.
Less prominent but still crucial to the Fed’s strategy is the role of inflation expectations, where there have been some dramatic developments since the start of the year.
As 2021 began, Fed policymakers have sent strong signals they are dead serious about pushing up inflation, even as market indicators of inflation expectations rose significantly. They have put a lot of emphasis on the need to further boost expectations to help get inflation over 2%.
The closely watched five year/five year forward “break even” inflation expectation rate, which measures expected inflation in the second half of a 10-year period, has risen from as low as 110 basis points last March to 211 basis points. About the same time, the 10-year Treasury note surged above 100 basis points, having been as low as 56 basis points last March.
Far from being alarmed, officials have celebrated the increase in break evens as proof markets “get it.”
“Since we announced the framework in August, there is plenty of evidence that market participants have shifted their expectations in ways that are consistent with the framework,” Fed Chairman Jerome Powell said in a webinar hosted by Princeton University on Jan. 14. “Surveys now show that market participants expect us not to raise rate interest rates until inflation has reached 2% and until the labor market is very strong indeed.”
When asked whether he is concerned about 10-year break evens going above 2%, Chicago Federal Reserve Bank President Charles Evans indicated quite the contrary in early January remarks to the National Association for Business Economics.
“I think that it’s very important that we average 2% inflation and so we’ve got a ways to go, and so even if we were to get a pop on year-over-year inflation and it lasted for awhile, well you know that would be a good thing if consistent with stronger underlying inflation, and then maybe we could get to our 2% average sooner than what I have (forecast),” said Evans, one of this year’s FOMC voters.
“Now, if everyone’s expectations are clear that the Fed is going to continue to go all-out with full-throated communications about how important it is to get inflation up maybe expectations will go up, and maybe that would solidify underlying inflation trends there,” he added.
Cleveland Federal Reserve Bank President Loretta Mester, once considered a “hawk,” expressed similar sentiments.
Because “resource slack in the labor market and in product markets has become less correlated with actual inflation” and because “inflation expectations now play a larger role in determining inflation outcomes,” she said it has become “even more important that inflation expectations remain well anchored at levels consistent with our longer-run 2 percent inflation goal.”
So, Mester said, “not only will we be comfortable with serendipitous shocks that move inflation above 2%, but we will set policy to intentionally move inflation moderately above 2% for some time.” This implies that “monetary policy will be somewhat more accommodative than in the past when inflation has been running persistently low in order to reach our longer-run inflation goal.”
Fed Governor Lael Brainard, a possible Powell successor next February if he is not nominated for a second term, seemed only partially pleased with the recent run-up in inflation expectations in Jan. 13 remarks. She wants more.
“Market expectations appear to have adjusted in response to the changes in the FOMC’s approach,” she noted, but “even though some of the survey-based measures of inflation expectations have picked up recently, they still remain close to the lower end of their historical ranges.”
“Market-based measures of inflation compensation have also picked up,” Brainard continued. ‘While disentangling inflation expectations from liquidity and term premiums is imprecise, staff models attribute a significant portion of the movement in inflation compensation to an increase in expectations, bringing them up from the lows seen in March but still below their historical averages.”
The latest dual mandate readings show unemployment at 6.7%, but though that is down sharply from last year’s 14.7% peak, it is thought to understate the degree of joblessness, given decreased labor force participation.
Inflation, as measured by the price index for personal consumption expenditures excluding food and energy, at 1.4%. FOMC participants project overall and core PCE inflation to run 1.4% in all of 2021. They don’t see it reaching 2% until at least 2023.
Fed policymakers see this as a prescription for sustaining aggressive monetary easing, coupled with fiscal stimulus.
Powell expects an increase in inflation in coming months, but not a lasting one.
“In the near term as the pandemic recedes and we see potentially a strong wave of spending as people return to their normal lives and consume various services, there could be quite exuberant spending, and we could see some upward pressure on prices and by the way at about the same time we see measured inflation go up because of base effects … that reflect the low rates of March and April of last year.”
“But the real question is how large is that effect is going to be and will it be persistent, because clearly a one-time increase in prices is very unlikely to be persistently high inflation,” Powell continued. “And that is just a function of the underlying inflation dynamics of the U.S. economy as they’ve been for the last many years.”
“We have a flat Phillips Curve,” he said. “There’s still a small connection, but you’d need a microscope to find it between slack in the labor market and inflation.”
“You also have low persistence of inflation,” Powell went on. “So if inflation were to go up for any reason, it doesn’t … stay up.”
Even if the economy strengthens sustainably after mid-year, Powell indicated the FOMC is unlikely to react as it has in the past and act to preempt inflation.
“Remember, we’re still a long way from maximum employment,” he said. “There’s plenty of slack in the labor market. It’s unlikely wage pressures are going to be reaching a level that would create and support higher inflation.”
So don’t look for any firming of monetary policy this year, either in terms of short-term interest rates or the Fed’s balance sheet.
“Now is not the time to talk about exit,” said Powell, who is uncomfortable even talking about lifting off or tapering.
“That is another lesson of the global financial crisis – to be careful not to exit too early and, by the way, try not to talk about exit all the time, … because the markets are listening,” he said. “The economy is far from our goals, and … we are strongly committed to our framework and using our monetary policy tools to do the job.”
The funds rate is the Fed’s primary policy tool, and the FOMC has been very clear about that. In its December Summary of Economic Projections (SEP), it is projected to remain in the zero to 25 basis point range through 2023.
Given the high bar the FOMC has set for meeting its inflation objective, liftoff could be even further in the future, although some officials allow for the possibility of acting sooner. Kansas City Fed President Esther George said, “if inflation tips over 2% I don’t think you’re going to find the Federal reserve reacting to that,” but “if inflation takes off in ways that are unanticipated, that of course require some decisions to react to that.”
Powell said that “if inflation were to move up in ways that were unwelcome … we have the tools” to combat it, but added “too low inflation is the more difficult problem.”
Under the FOMC’s redefined employment goal, “We will react now only to shortfalls from maximum employment,” he said. “That reflects our view that employment can run at or above our real-time estimate of the maximum level without causing concern unless accompanied by signs of unwanted increase in inflation or other risks that could impede the achievement of our goals.”
Powell added, “We’re no longer going to raise interest rates just because, for example, the unemployment rate is well below our current estimates of the natural rate of unemployment. That wouldn’t be a reason to raise interest rates unless we see troubling inflation or other imbalances that could threaten to (undermine the economy).”
There is much more uncertainty about the Fed’s other major tool – asset purchases – than about the funds rate.
There is linkage between the two tools. At the Nov. 4-5 FOMC meeting, “most participants judged that the guidance for asset purchases should imply that increases in the Committee’s securities holdings would taper and cease sometime before the Committee would begin to raise the target range for the federal funds rate.”
So, first will come tapering and only then liftoff. But the lag-time is anyone’s guess at this point.
Financial markets are anxious to know when the Fed will start “tapering” monthly asset purchases from the current $80 billion of Treasury securities and $40 billion of agency mortgage backed securities. Alternatively, they wonder whether the Fed will beef up or otherwise alter its asset purchase program.
While the FOMC will no doubt have further discussions of the balance sheet options, it is unlikely to make any changes at the upcoming meeting.
At the December 15-16 FOMC meeting, minutes reveal little sympathy for tinkering with asset purchases. There was a thoroughgoing discussion of the asset purchase program, but not a lot of movement toward a change in its size or composition. “All participants judged that it would be appropriate to continue those purchases at least at the current pace, and nearly all favored maintaining the current composition of purchases.”
Only two spoke in favor of “weighting purchases of Treasury securities toward longer maturities.”
The minutes did refer to potential future changes at some vague point in the future: “Some participants noted that the Committee could consider future adjustments to its asset purchases – such as increasing the pace of securities purchases or weighting purchases of Treasury securities toward those that had longer remaining maturities – if such adjustments were deemed appropriate to support the attainment of the Committee’s objectives.”
But the minutes did not convey any sense of urgency.
There was also a discussion of how the program would evolve once the goal of “substantial further progress” had been achieved, but again no hint of near-term changes: “A number of participants noted that, once such progress had been attained, a gradual tapering of purchases could begin and the process thereafter could generally follow a sequence similar to the one implemented during the large-scale purchase program in 2013 and 2014.”
That’s a reference to the FOMC’s gradual shrinkage of large-scale asset purchases (LSAPs) in 2013, when the Fed initially cut purchases from $85 billion to $75 billion per month and made further reductions subsequently.
There was a suggestion that the asset purchase program would respond flexibly to future economic and financial developments. FOMC participants felt the new guidance language “offered more clarity about the role played by the asset purchase program in providing accommodation to meet the Committee’s economic goals, and underscored the responsiveness of balance sheet policy to unanticipated economic developments.”
“A few participants stressed that all of the Committee’s policy tools were now well positioned to respond to the evolution of the economy,” the minutes say.
“For example, if progress toward the Committee’s goals proved slower than anticipated, the new guidance relayed the Committee’s intention to respond by increasing monetary policy accommodation through maintaining the current level of the target range of the federal funds rate for longer and raising the expected path of the Federal Reserve’s balance sheet.”
For now, the predominant view at the Fed is that asset purchases are “well-calibrated,” and there is hesitancy to hint at any change, least of all in a downward direction.
For instance, Powell said the so-called “taper tantrum,” which ensued in 2013, after then-chairman Ben Bernanke hinted at a coming reduction of asset purchases, “highlights the real sensitivity that markets can have on asset purchases, so we know we have to be very careful in communicating about asset purchases.
Powell stressed that there is no predetermined timetable for tapering. “We always try to avoid an excessive focus on a particular likely path or modal path of the economy, because monetary policy is only sometimes about the most likely path, it’s often about … risk management to avoid downside cases. So that’s a little bit why our guidance on both rates and asset purchases is not time-based, it’s outcomes; it requires the achievement of various objectives, and those objectives will come when they come, not (by) the calendar… . You really can’t do that.”
Powell pledged to be “very very transparent as we get closer…. (W)hen it does become appropriate for us to discuss specific dates – and that will be when we have clear evidence that we are making progress toward our goals and are on track to make substantial further progress toward our goals – when that happens and when we can see that clearly we will let the world know.”
“We will communicate very clearly to the public, and we will do so well in advance of active consideration of beginning a gradual tapering of asset purchases,“ he added.
A day before Powell, Brainard made clear she sees no need to reduce asset purchases and, if anything, may need to increase them.
“The economy is far away from our goals in terms of both employment and inflation, and even under an optimistic outlook, it will take time to achieve substantial further progress,” she said. “Given my baseline outlook, I expect that the current pace of purchases will remain appropriate for quite some time.”
In assessing “substantial further progress,” Brainard said she “will be looking for sustained improvements in realized and expected inflation and will examine a range of indicators to assess shortfalls from maximum employment.”
Far from reducing bond buying, she said she and her colleagues “stand ready to increase those amounts if we judge that to be warranted.”
Brainard said “the timeline for lifting the policy rate off the lower bound or adjusting asset purchases will depend on realized inflation and realized employment.”
“We’re far from those goals currently,” she added. “So it’s too early to say how long it will take” to taper asset purchases or to lift off from the zero lower bound.
Realistically, the earliest we can expect any adjustments to LSAPs is sometime in the Spring. Almost certainly, any adjustment would be toward an increase. Another possibility would be a lengthening of the weighted average maturity.
Evans broached the possibility of a Spring augmentation of quantitative easing.
“(T)he most important thing … is that we go out with full throated confidence and advice and say we’re going to be there to provide accommodation to absolutely make sure we get inflation up to 2% and overshoot and average 2% over time and continuing to follow through on our long-run framework … and then as we get into spring … (decide) whether we need additional commentary about asset purchases or changes in tuning that up.”
Elaborating, Evans said, “I think that, come the springtime, as we know better how things are going to play out – the next administration, the vaccine roll-out and things like that – we will be better positioned to sort of understand what types of accommodation from monetary policy are needed, essential.”
Of course, the timing of a “Spring” QE adjustment is open to interpretation, given that Spring runs from March 20 to June 20 this year.
But there’s no guarantee the FOMC will make any changes to LSAPs in the Spring.
Vice Chairman Richard Clarida said his economic outlook is “consistent with us keeping the current pace of purchases throughout the rest of this year.’
As for reducing the amount of purchases, Clarida suggested the Fed will be in no hurry to do that: “I think it could be quite some time before we would think about tapering the pace of our purchases the way I look at the data, and I’m relatively optimistic about the economic outlook.”
“We want further progress in the labor market and moving toward our 2% inflation objective, and I think that’s some ways away before we declare victory on that,” he added.
Atlanta Fed President Raphael Bostic, another of this year’s voters, raised a few eyebrows when he seemed to open the door to an earlier tapering by saying he is ‘hopeful that in fairly short order we can start to recalibrate.”
But Bostic clouded the water by saying it would be “difficult” to diagnose ongoing economic effects of the virus for awhile and by saying he is “hopeful that moving on into this year that the signals for weakness start to dissipate and the conversation turns consistently and robustly to sort of steady and broad-based growth.”
And a week later Bostic seemed to extend the horizon. “I think the forward guidance that we’re putting out into our statements is also providing a clear signal about the way we think about things, and I would like to get those in a more normalized place before we move our policy rate.”
“I think there is some possibility the economy could come back a bit more strongly than some are expecting, and if that happens I’m prepared to support pulling back and recalibrating a bit of our accommodation and then considering moving the policy rate,” he continued.
“But I don’t see that happening in 2021,” he went on. “A whole lot would have to happen for us to get there, and then we’ll see into 2022, maybe the second half of 2022, or even 2023, whether that might be more in play.”
Bostic said “the most important takeaway that people should have is that we’re going to be monitor, and we’re going to do what’s appropriate given the information we have at the time. And we’re not locked into a particular length of time of having any kind of policy stance.”
“We really want our policy be informed by what we’re seeing on the ground and make adjustments to our policy stance based on that,” he added.
Nor is there much support for any kind of monetary tightening among non-voters.
Boston Fed President Eric Rosengren said he’s “optimistic that we will see significant employment gains over the next two years,” but said, “I do not expect the U.S. economy to reach a sustained 2% inflation rate over the same time frame….” which “implies that policymakers will continue to maintain very accommodative short-term rates.”
Rosengren said he “expect(s) that short-term interest rates near zero will be appropriate throughout this year, and that the Federal Reserve will continue to purchase long-term assets until the economy is on a stronger economic footing.”
Though not part of the “dual mandate,” financial stability also became an avowed Fed goal in the aftermath of the financial crisis, and there are a few Fed voices – Mester, George, Rosengren – cautioning that keeping rates too low for too long risks financial instability.
But such concerns are unlikely to sway monetary policy in the foreseeable future. Mainstream thinking is that “macro-prudential” policies (supervision and regulation) are the proper tools for countering financial stability risks.
Meanwhile, on the fiscal front, former Fed Chairman and Treasury Secretary-designate Janet Yellen, is urging Congress to “act big.” Accordingly, the incoming administration is preparing a $1.9 trillion federal spending package – on top of last year’s $2.9 Covid relief legislation and the recent $900 billion fiscal stimulus.
Current Fed officials are all in on massive deficit spending and the attendant accumulation of debt. Asked about that, Powell said this is not the time to worry about that.
He said the level of federal debt is “far from unsustainable,” and he said the United States is “a long way from fiscal dominance” – a scenario in which the government’s debt has become so huge that the central bank must focus primarily on helping the government fund its obligations.
The debt “doesn’t impact monetary policy now,” Powell asserted.
No, not now….
Contact this reporter: steve@macenews.com.
Content may appear first or exclusively on the Mace News premium service. For real-time delivery contact tony@macenews.com. Twitter headlines @macenewsmacro.