By Steven K. Beckner
(MaceNews)– With each passing day, as the recovery continues (and as more Americans get vaccinated), we are getting closer to the time when the Federal Reserve starts tapping the brakes on its supercharged monetary race car.
But that doesn’t mean it’s close, and it’s doubtful we will see any perceptible movement away from the Fed’s ultra-loose monetary policy stance at its March 16-17 Federal Open Market Committee meeting.
Far from it. All indications are that the FOMC remains quite some distance from reducing the pace of its aggressive bond buying, much less lifting short-term interest rates off the floor.
So expect the FOMC to keep the federal funds rate in the zero to 25 basis point range it’s been in and to keep buying $80 billion of Treasury and $40 billion of agency mortgage backed securities per month until it sees “substantial further progress” toward its maximum employment and average 2% inflation goals – the latter including a planned overshoot “for some time.”
Since the Committee last met in late January, the economy has improved with the steady advance of anti-Covid vaccination throughout the United States, and FOMC participants will reevaluating the outlook as they compile their quarterly Summary of Economic Projections (SEP) at the upcoming meeting.
As always, each official’s projections of GDP growth, unemployment and inflation will be predicated on his or her assessment of the “appropriate” monetary policy as expressed in accompanying federal funds rate projections.
Also included, though unstated, in officials’ assessments and forecasts are sure to be assumptions about fiscal policy – that is, how much supplemental stimulus they expect the economy to get from the soon-to-be enacted $1.9 trillion Covid “relief” bill, which comes on top of a $900 billion package signed into law in December.
Chairman Powell and many of his colleagues have openly lobbied for more “fiscal stimulus” in non-specific terms, calling it “essential” and saying monetary policy “can’t do it alone.” Now they are getting their wish, but that doesn’t mean FOMC participants will trim their funds rate projections. In the December SEP, participants projected the funds rate will stay near zero through 2023, and it seems unlikely that will change, although individual funds rate projections could vary.
The SEP, of course, does not include projections for the quantitative aspect of monetary policy, i.e. its large-scale asset purchases. But the FOMC will let us know its quantitative easing plans in its policy statement. It would be very surprising if the FOMC were to slow the pace of its $120 billion per month bond buying – or for that matter hint at doing so anytime soon.
Fed watchers will hang on every word Powell has to say on that subject and others. Thus far, neither he nor any of his colleagues have hinted a “tapering” of asset purchases is on the horizon.
The Fed puts a high premium on clear communication, or “transparency,” and it behooves us to pay close attention to what Powell and his fellow policymakers have been saying with a remarkable degree of unanimity,.
Gone are the days when the Fed, under leaders like Paul Volcker, liked to surprise markets occasionally. For quite some time, the guiding philosophy has been that monetary policy is most effective when the Fed and the markets are in synch. If anything, that belief has grown stronger in recent years, as the Fed has sought with its rhetoric to shape financial conditions, smooth market perturbations and avoid “tantrums,” such as the famous one that ensued in 2013, when bond yields leaped even though then-Chairman Ben Bernanke thought he had prepared the ground for the coming “tapering” of the third round of “quantitative easing” (QE3).
The spike in bond yields of Thursday, Feb. 25, of which Fed officials took due notice, served as a reminder that they’d need to be clearer than ever with the signals they’re sending.
So don’t be surprised if no surprises emerge from the FOMC’s March 17 policy statement, from the accompanying Summary of Economic Projections (SEP) or from Powell‘s afternoon remarks to reporters.
The revised SEP will certainly be of interest, but it should not surprise anyone if the collective economic forecasts look a little rosier. After all, we just got a bigger than expected 379,000 February non-farm payroll gain, and the Atlanta Federal Reserve Bank is now projecting first quarter GDP growth of 10%, as consumer spending rebounds sharply.
But forecasts of stronger growth and lower unemployment won’t necessarily translate into higher projections for the federal funds rate. That would be a surprise.
Fed officials have been sounding a number of basic themes in the run-up to the meeting, and they all point in one direction, at least for now and for the foreseeable future: : unabated monetary ease.
The common themes of Powell and his colleagues have been:
- The economy faces tremendous uncertainty – about the virus, about fiscal policy, etc.;
- Despite a recovery that has lowered the unemployment rate to 6.2%, the economy remains far from the Fed’s maximum employment and 2% average inflation goals;
- Inflation may rise in coming months, but the Fed should look through the expected “temporary” price surge
- Monetary policy needs to stay accommodative for a long time and needs help from fiscal stimulus
- The Fed must exercise “patience” in pursuit of its goals
- The Fed must see “actual data” showing “substantial further progress” – not mere forecasts
- Before it tightens, the Fed will “clearly communicate… well in advance.”
The message has been unmistakable: there is no rush whatsoever to firm monetary policy, either through diminished bond buying to hold down long-term interest rates or through short-term rate hikes. Implicitly too, Fed rhetoric strongly suggests a long lead-time for any policy shift.
For the present the real policy question is not when the FOMC will raise the funds rate, although the anticipated timing of short-term rate increases does affect rates across the yield curve, but rather when the FOMC starts slowing asset purchases. The FOMC let it be known in minutes of the November meeting that reducing the pace of bond buying is a prerequisite for liftoff: “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.”
But the Fed has a problem – the bond market, its relationship with which could become more and more treacherous.
While T-bill and other short-term interest rates have fallen toward zero, long-term rates have soared. As this was written, the 10-year Treasury note yield stood at 1.603% – up from 0.9170% at the start of 2021, and as low as 0.3980% last March.
It would appear that, although the Fed may no longer believe very much in the theoretical Phillips Curve trade-off between unemployment and inflation, the bond market clearly does. Market participants are convinced above-potential GDP growth, a tightening labor market will drive inflation higher and force a reluctant Fed’s hand, much as in the past.
The Fed faces a major communications challenge. By vowing to keep monetary policy loose while cheering massive additional fiscal stimulus the Fed may be setting itself up for an even bigger confrontation with those notorious bond market vigilantes.
The run-up in bond yields has been attributed to fears that the Fed will raise interest rates sooner than expected, but that in turn is predicated on the belief that accelerating GDP growth and falling unemployment rates will boost inflation and force the Fed to tighten. Real rates are rising, but so are inflation expectations.
The five-year breakeven rate – the spread between yields on five-year Treasury notes and Treasury inflation-protected securities of the same maturity — has jumped from 1.98% at the start the year to 2.45% recently.
The Fed’s response to the dual increase in breakevens and nominal yields has been to profess a lack of concern — indeed to welcome the phenomena as encouraging signs that the economy is recovering, that its own policies are working and that the markets “get it” that the Fed is serious about pushing inflation “moderately” above 2 “for some time.”
Far from bowing to market inflation fears the Fed has continually reaffirmed determination to keep rates low as long as it takes to get back to a far more encompassing definition of “maximum employment.”
The Fed openly admits an upsurge in prices is coming but dismisses it in advance as sure to be “transitory.”
But what happens if the combined heat of monetary and fiscal stimulus under the proverbial economic threaten to blow the lid off of the proverbial economic kettle. Fed officials are confident higher inflation won’t persist because of 30 years of low and stable inflation expectations.
What if they prove wrong? No problem, say Powell et al. If inflation becomes “troubling,” they confidently assert, “we’ve got the tools” to beat it back.
What they don’t talk about is their not-so-secret weapon – the Fed’s ability to bottle up much of the money it is creating through asset purchases. The Fed is paying banks to hold reserves at the Fed, which restrains their lending and in turn limits the creation of demand deposits.
But as demand for credit in an expanding economy increases, and as the velocity of money presumably increases, those limits will be tested.
The Fed hopes it can continue countering the steepening of yield curve with words, not action. There is little appetite for increasing asset purchases to try to hold down long-term rates. Nor is there much appetite currently for formal “yield curve control” – essentially setting caps on yields.
A more likely option, which the staff will may well present to the FOMC in their greenbook, is increasing the average duration of asset purchases, i.e. buying more long-term Treasuries. San Francisco Fed President Mary Daly, a voter this year, said last week she is open to reviving “Operation Twist” (buying long-term securities; selling short-term securities), which the FOMC used 2012 in conjunction with QE to good effect.
Daly had misgivings about yield curve control when I asked her about it: “If you go to yield curve control, you’re controlling the price, and the quantity is the free variable,” she continued. “So if you worry about the size of the balance sheets for all kinds of reasons, ranging from the mechanics of how markets work to the optics of a large balance sheet, whatever your interest is, if you lose control of the balance sheet size, then you’re saying you’re indifferent to those outcomes.”
“I think we have to be serious in considering that you can only control one variable – price or quantity,” she went on. “So you have to pick which one you want to control by figuring out which one has the most target efficiency in terms of getting the outcome you want, which is accommodative monetary policy.”
Chicago Fed President Charles Evans, another voter, said last week the Fed could resort to resurrecting Operation Twist, but said neither that nor yield curve control are under active consideration.
For now, Fed officials seem content with what used to be called “jawboning.” Collectively, they have been trying to walk a thin line. They want to tamp down concerns about rising yields — nearly welcoming them as encouraging signs on the economy and inflation expectations — while at the same time conveying the message that tightening is not on the horizon, yet giving themselves flexibility to adjust policy eventually as the data allow. It’s a tricky game, especially given their promise to communicate any shift “well in advance.”
In two days of Congressional testimony, Powell seemed to strongly signal he feels no urgency about altering policy in any respect by repeatedly talked about the need for “patience” and for “actual data” showing “substantial further progress” toward the employment and inflation goals – not merely forecasts of progress. He largely reiterated those points last week.
In ensuing days, other officials echoed his words. Daly, for instance, said “We’re going to have to have a big dose of patience in the summer,” because inflation could well rise above 2%, but this would likely be “short-lived.”
The FOMC will be “looking at the underlying inflation rate” and “looking at all measures of full employment.” she added.
Fed Governor Lael Brainard also made clear she doesn’t think the FOMC should rush to reduce monetary accommodation in any way. Echoing Powell in putting actual unemployment closer to 10%, she said she “will be looking for sustained improvements in realized and expected inflation and examining a range of indicators to assess shortfalls from maximum employment” before concluding there has been “substantial further progress.”
Brainard, a potential successor to Powell when his term expires next February, said last week that, in assessing when there has been “substantial further progress” sufficient to consider tapering, she “will be looking for realized progress toward both our employment and inflation goals.”
“I will be looking for indicators that show the progress on employment is broad based and inclusive rather than focusing solely on the aggregate headline unemployment rate, especially in light of the significant decline in labor force participation since the spread of COVID and the elevated unemployment rate for workers in the lowest-wage quartile and other disproportionately affected groups,” she added.
Brianard said she also “will carefully monitor inflation expectations,” but emphasized, “it will be important to achieve a sustained improvement in actual inflation to meet our average inflation goal.”
“The past decade of underperformance on our inflation target highlights that reaching 2% inflation will require patience, and we have pledged to hold the policy rate in its current range until not only has inflation risen to 2% but it is also on track to moderately exceed 2 percent for some time,” she said.
For now, Brainard said, “the economy remains far from our goals in terms of both employment and inflation, and it will take some time to achieve substantial further progress.” Noting payrolls are still 10 million below the pre-COVID level, and inflation has been running below 2% for years,” she reiterated, “We will need to be patient to achieve the outcomes set out in our guidance.”
To be sure, it’s possible the Fed could tighten sooner than it now signaling, were the economy to really booms and inflation were to become “troubling.” But that calls for a forecast few of us are qualified to make.
We must allow for the reality that Fed communications are preparing the ground for an eventual policy shift, although we are still in the early days of setting the stage for consideration of tapering.
Since the FOMC has deliberately not set any thresholds or triggers, they have given themselves flexibility to make qualitative assessments of progress toward the maximum employment and average 2% inflation objectives. These assessments can then be conveyed by nuances of language – endlessly repeated until the FOMC is confident Fed watchers have gotten the message.
Depending on how the economy progresses as the virus is presumably brought under control, as fiscal stimulus kicks in and as accumulated savings are converted into spending, Powell and company can incrementally let it be known that “substantial further progress” is being achieved.
The same flexible “outcome-based” forward guidance now being used to signal delay of monetary normalization could be used to accelerate the process if economic and financial conditions evolve favorably.
Who knows? Perhaps, the FOMC will conclude in coming months that “substantial further progress” has been reached sooner than they expected; that the balance of risks has moved more toward the upside; that they’re closer to full employment than they had anticipated, and that inflation expectations are propelling actual inflation toward their goal faster than expected.
Fed watchers will need to be alert to those kinds of utterances – if things actually unfold that way. But the recent rhetoric of Powell and others suggests they are nowhere near ready to start advance signaling, which in turn means actual tapering might be far off.
For now, Powell and his colleagues are actively discouraging speculation about an early tapering, partially in an effort to keep a leash on market expectations and bond yields.
I’ve been asking various officials for clarification on the timing of tapering and about how far in advance the FOMC will start signaling that it is imminent. My basic question has been: with all the talk about the need for “patience” in an economy “far from” the Fed’s mandate goals and facing great uncertainty, and given the promise to “clearly communicate …. “well in advance,” doesn’t all that imply that the FOMC is a long way from seriously considering slowing the pace of asset purchases?
No one I’ve talked to disputes the premise of that question.
One such official is Evans, who last month said that deciding when there has been “substantial further progress” will come down to looking at the data and having a “conversation” about it. But the FOMC hasn’t even “started the conversation,” he added.
“In terms of inflation I really don’t have any interest in adjusting policy on the basis of an inflation forecast without also seeing that inflation is going up,” he said. “I think we’ve had that type of experience in the past, and I’m really part of the ‘show me’ the inflation (group). … I think I need to see the inflation and feel confident that it’s on track to overshoot.”
One gets the impression that achieving “maximum employment” is even more important in determining the timing of policy changes. And remember that that goal has been redefined as “broad and inclusive.” The FOMC has declared it will be looking not just at the headline unemployment rate, but at employment-population ratios, labor force participation and other metrics, and they want to see declines in minority unemployment to achieve “broad and inclusive.”
So to trim asset purchases the FOMC will need to see the clouds of uncertainty dissipate and see not only actual evidence of sustained 2%-plus inflation, but also proven progress toward full (and diverse) employment. Although officials have become more optimistic, they have set a high bar for achieving both inflation and employment goals.
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Contact this reporter: steve@macenews.com.
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