With the Federal Open Market Committee’s year-end meeting set to conclude a week from today, we wanted to offer a few points on what we expect will be its main takeaways:
*** The first is fairly obvious by now, that as we wrote just before the November meeting Minutes (SGH 11/23/20, “Fed: The Minutes and the December Meeting”), the odds for a shift in the Fed’s $80 billion a month in treasury purchases to longer maturities are very slim. Most of the FOMC believe it would be the wrong policy response to the current economic weakness, and many question the efficacy of QE when yields are already so low and when the cost-benefit trade-offs on financial stability risks are not insignificant. Both those factors are driving how the Fed’s reaction function is being adapted to the policy constraints at the effective lower bound, ultimately aiming not necessarily to lower yields but to smooth out their eventual rise as the economy recovers. ***
*** The FOMC is instead all but certain to focus on how to best align the guidance language on balance sheet policy to the rates guidance in place since September. We don’t have the sense, though, there is much yet in a consensus on the exact phrasing to the “outcome-based qualitative threshold” for balance sheet policy described in the November Minutes. That said, we expect the guidance will probably tether asset purchases to improvements in the labor market and a vaguely-defined “approaching maximum employment” threshold. The lack of the specifics is thought to offer flexibility down the road on when and how to signal a period between the tapering of asset purchases and the eventual rates-lift off. ***
*** The newly revamped Summary of Economic Projections – an “infusion index” will be added, and the whole of the SEPs will be brought forward to the day of each meeting statement – will be important in how the projections convey the highly bi-modal near term weakness and a likely robust rebound in spending and growth, assuming the vaccines work and are widely distributed. Prior growth forecasts had already penciled in a large fiscal support package, which means the near term risk to growth is a failure to provide a near $1 trillion fiscal income and state support package. But the far more interesting risk will be to the upside next year, another reason for the FOMC’s caution on when and how to undertake any further accommodation. ***
The Debate Over Balance Sheet Guidance
Since the September FOMC meeting, which laid out the new rate guidance, the Committee has been eyeing their December meeting next week for when the next phase of the new framework would be put into place on balance sheet policy. While there is a near consensus within the Committee to push any further accommodation through balance sheet policy into next year, the intention remains to at least lay out a more powerful forward guidance framed with an outcome-based but qualitative threshold.
But our sense is that settling on the exact new balance sheet guidance language is proving to be more complicated than many Fed officials envisioned just a few weeks ago. The current “over coming months” of increasing its treasury and MBS purchases “at least” at the current $120 billion pace, not only to sustain market function but to “help foster accommodation conditions,” may in fact have to carry the communications for another meeting or two.
We doubt the Committee will feel comfortable with a repeat of the status quo, however, which we suspect points to a more explicit labor market threshold, albeit one that would remain vaguely defined along the lines of maintaining asset purchases until the labor market is “approaching maximum employment.”
How the FOMC defines maximum employment will probably be fleshed out in the post-meeting presser, and in subsequent speeches and interviews rather than the formal statement. But it will be safe to assume “maximum” employment will be lower than the longer run estimates for unemployment that will still feature in the SEPs, as well as far more granular than just the headline number to ensure minority, gender, and age sub-sectors of the labor market are taken into an accounting of the “shortfall” in employment.
And it is interesting to us that not a single Committee member offered much about what it would take to trigger further accommodation, with nearly all instead seeking to temper market expectations of when and how quickly the FOMC will taper the asset purchases, and how much of an intermediate period there is likely to be between the end of tapering and the eventual rates lift-off.
In that sense, one of the attractions to keeping the balance sheet policy guidance to a somewhat vaguely defined labor market threshold is the flexibility it offers to refine the threshold and asset purchases down the road, depending on how the economy and labor market evolves, and because a tight labor market should, almost by definition — the abandoned reliance on a flattened Phillips Curve notwithstanding — well precede the inflation target mark, thus leaving plenty of time to taper the asset purchases without undercutting the rates guidance and triggering a redux of the 2013 taper tantrum.
In any case, the Fed wordsmiths will be thumbing through their dog-eared thesauruses to come up with at least three different phrasings and sentences for the Committee to wrestle with before settling on the final wording of the statement. Chairman Jerome Powell will then seek to explain and make a sales pitch in the post meeting presser. One safe best guess is he will be sure to avoid suggesting the balance sheet is on “auto pilot.”
The QE Issues
We doubt there will be any change in the current pace of asset purchases next week, despite the mention of potentially reducing their amount in the November Minutes. But it would be noteworthy if, as we suspect likely, the Committee chooses to keep an affirmation of a continued $80 billion and $40 billion a month in treasury and MBS purchases in a separate sentence from the new guidance formulation.
The reason would be to leave some wiggle room down the road for what we think is an FOMC ambition to reduce the current $120 billion a month in treasury and MBS purchases to perhaps no more than $80 billion a month, probably coupled to if and when the Committee opts to add further accommodation to help sustain the recovery. After all, the $80 billion of month in current treasury purchases, even if across the curve, is already taking out as much or more duration as QE2, and a shift to a weighted average maturity, even with the lower total purchases, could still have the same duration effects of QE3 at its peak.
Indeed, the benefits to waiting until the March meeting or later in constructing additional accommodation, which for now seems likely to us, is not only the greater clarity on fiscal policy, the progress of the Covid vaccines, and the state of financial conditions, but that each of those may go a long way to shaping how the most optimal form of accommodation will be structured: whether in terming out the treasury purchases to the longer end – probably still the favored path – another Maturity Extension Program, depending on potential reserve market pressures on short rates or, even if not on the table at present, yield curve caps.
We also had a sense of a “pre-emptive” easing being considered in December through the terming out of the existing asset purchases that may help a little in pushing yields down in the near term but mostly aimed at pre-positioning a more powerful accommodation once the recovery is underway. But we frankly found little resonance on that easing strategy.
There is also no small amount of market conjecture that politics could enter into the FOMC decisions next week, namely a Board versus District pressure to either “reward” Congress and the Trump Administration in its final days with a QE fillip for finally passing critically needed fiscal policy income and state support, or in the opposite direction, if Congress drops the ball yet again or the economy as soon as next week is turning more deeply towards a deeper than expected near term recession.
But our sense is that the perceived politics of a FOMC decision are misplaced: for one, district presidents would revolt against such an assumed Board-driven move, and in any case, we just don’t think anyone on the Board of Governors, including the Chair, is even thinking in those immediate terms of responding to Congress. Rather, the period of a likely policy cooperation will come next year, probably by spring (see SGH 12/1/20, “Fed: The Yellen-Powell Nexus”).
An Evolving Reaction Function
One last point is that we think the prior elevated market expectations for more accommodation in December may have been premised on a wrong understanding of how the Fed’s reaction function is evolving in the context of the new policy framework.
For one, a further easing in December is seen across the Committee as the wrong policy tool to counter the near term weakening in growth. Monetary policy operates with a lag, as every Fed official with a central bank membership card will attest, and the current outlook is of a deep downdraft in the near term that is likely to be followed by a powerful burst of repressed spending that could drive a recovery in the medium term as steep as the near decline is deep.
Perhaps more importantly, many if not most of the FOMC and staff have increasingly come to question the effectiveness of the transmission of accommodation through QE into the real economy when yields are already this low. On this front, much of the new thinking and skepticism over the efficacy of QE at the ELB was already sketched out in the staff memo “Issues in the Use of the Balance Sheet Tool” that Chairman Powell footnoted in his Jackson Hole speech in August when he laid out the new framework.
And that, in turn, underscores a key takeaway that we think lies in another feature in the evolution of the Fed’s reaction function when policy is constrained at the effective lower bound and when yields are already so low.
While further easing will always be on the table in the face of a deepening downturn, even if its impact is limited, our sense is that the Powell-led Fed envisions the optimal monetary policy path under the current economic outlook will be in maintaining easing into economic strength, not weakness; that is to say, balance sheet policy would be used not primarily to lower yields from here, but to slow or dampen their eventual steepening as the economic recovery gathers momentum.
And that is another way of saying an aggressive and sustained fiscal policy must take the lead in driving aggregate demand and job creation, which is why almost every FOMC member from the Chairman on down is begging Congress to step up this time, not just in the coming week or so in the last leg of the negotiations over the fiscal supplementary package, but in the scale and ambitions of the fiscal year 2022 budget.
In that scenario, monetary policy through the balance sheet would provide a secondary support role, extending a period of accommodative financial conditions even as the recovery is gathering momentum and which will better ensure the Fed is able achieve its twin mandates.