After the first meeting of policymakers since the US central bank laid out its new policy framework, the Fed said it was committed to using its full range of tools to support the economy and promote maximum employment and price stability amid the 'tremendous human and economic hardship' caused by the coronavirus crisis across the country and worldwide.
Leaving the benchmark fed funds rate at 0.0%-0.25%, in line with market expectations, FOMC policymakers provided guidance on the circumstances under which they will lift interest rates off the floor. The wording was arguably a little disappointing and certainly not more dovish than expected.
The Fed said rates would be kept steady until labour market conditions improved and were consistent with its assessment of maximum employment, and inflation had risen to the 2% target and was on track to “moderately exceed [2%] for some time.” The possibility of inflation hovering above the target for a period had been introduced in the recently updated policy framework.
Clarifying the tolerance for above-target inflation
Fed Chair Powell clarified after the meeting that “moderately exceed” was not the same as a large deviation from the 2% target and “for some time” was shorter than a sustained period.
Central bank policymakers had indicated that the employment and inflation goals should have been achieved on a sustained basis – say, over the course of a year – before rates would be increased. Projections published after the latest meeting showed that the median forecasts of FOMC committee members were for inflation to return to 2% and unemployment to fall to 4% by 2023.
In our view, Powell’s comments are not dovish: if you do not want to engineer ‘large’ overshoots of target inflation at any point, you cannot wait too long with current interest rates at the floor once you expect inflation to overshoot at all.
What happens to asset purchases over the medium term?
More strikingly, there was no guidance on asset purchases (quantitative easing, QE) over the medium run. The Fed only said that “over coming months” asset purchases will continue “at least at the current pace to sustain smooth market functioning and help foster accommodative financial conditions”.
We believe most investors expect the Fed to continue with QE for years until the conditions are in place for rates to rise.
Commenting on the latest projections, the Fed said the data now looked a little better than the June numbers, with activity and employment having picked up in recent months. Growth over the year to Q4 2020 was revised up by almost three percentage points; the expected unemployment rate was a full percentage point lower in 2021 and almost a percentage point lower in 2022.
Clues needed on inflation, employment beyond 2023
It is worth noting that the median projections are for inflation to reach 2.0% in the fourth quarter of 2023 – at the same time as the unemployment rate falls to just below the long-run equilibrium rate, that is, the point at which demand for labour just exceeds supply and inflation could start to edge up. Wage inflation could be a trigger for the Fed to start raising interest rates.
In short, the projections start to become interesting at the very end of the forecast period. Inflation has just reached the target but we don’t know what the Fed expects to happens to inflation beyond this point. The message seems to be that rate increases are possible in 2024. That is corroborated by the ‘dot plot’ (see below), which has all but four FOMC members projecting rates on hold until the end of 2023.
Exhibit 1: Here is what FOMC participants expect to be the US fed funds rate over the 2020-2023 period (‘dot plot’; midpoint of target range in %)
Source: US Federal Reserve; Sept 2020
Given recent history, the expected recovery in inflation looks optimistic: Very low unemployment did not cause strong core inflation before the pandemic. That could suggest that rates lifting off could occur even later than 2024. And any major negative shock to the economy in the meantime could delay that.
There is relatively little the Fed can do to boost demand, with interest rates already at rock bottom. Policymaking is stuck at the lower bound waiting for good luck or good fiscal policy to reflate the economy.
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