Next Tuesday and Wednesday will see the return to regularly scheduled meetings of the Federal Open Market Committee that will, in a way, mark an end to the Great Lockdown and the pivot to the start next month for the tentative, rolling re-openings of the US economy.
** First, we think the April meeting is likely to be dominated by a review of the economy and of the efficacy of the Fed’s 13-3 liquidity facilities, and in particular, whether they have “flattened the curve” in the need for additional facilities to relieve persistent or new liquidity or market functioning stresses.
** The array of 13-3 facilities aimed at the capital markets have largely succeeded in restoring market functioning and liquidity, especially in the treasury market, modestly less so in the credit markets beyond investment grade. Collateral is over time likely to be further loosened, eligibility widened, and rates adjusted down as the Fed, we think likely, will be forced to move further down the credit curve. Additional facilities, perhaps aimed at the mortgage market, and especially greater regulatory forbearance also seem likely. The Fed’s unprecedented support to smaller companies and “Main Street” will draw cautious scrutiny at the meeting, especially in the face of likely solvency and credit loss issues in the second half of the year.
** With the progression of the coronavirus, and inconsistent state and federal policy responses topping a long list of unquantifiable risks, the economic outlook for the April meeting is being mapped out in two, maybe three, probability-based “scenarios” rather than point forecasts. There is a working assumption for staggered, partial re-openings of the economy beginning in mid-May, but there is considerable concern a wider opening could prove premature and trigger subsequent waves of infections that push a sustained recovery into 2021. The balance of risks is distinctly tilted to the downside in the second half of this year, while the whole year is likely to still see negative GDP growth.
** We believe the FOMC’s still evolving longer-term strategy is unlikely to feature to any significant degree at the April meeting, though we admittedly could be surprised if not impressed if it did or Chairman Jerome Powell offered details at his post-meeting presser, where he will be asked about monetary policy going forward. We expect the June meeting will be the earliest timing for the Committee to unveil its recession fighting strategy at the Zero Lower Bound.
** While it is obviously still evolving, the new framework, and transition from crisis fighting to recovery management, we believe is likely to entail a twin tracked, very aggressive lower for longer forward guidance on rates guided by mandate-consistent unemployment and inflation thresholds, and reinforced with an equally aggressive open-ended balance sheet expansion.
** Despite recent speculation over the merits of yield curve caps, the Committee seems reluctant to embrace explicit yield curve caps in the near term, or at least not before the scale of fiscal stimulus and its impact on the shape of the yield curve comes into a clearer focus. A flexible QE regime, on the other hand, that can be turned up, off, adjusted, or tapered as desired, matched with forward guidance, can in effect provide much of the benefit, without the loss of balance sheet control, of an YCC regime.
“Knightian Uncertainty,” Cubed
The data since early March and especially in that “cruelest month” of April, as Eliot wrote in the well suited poem for our current times The Wasteland, have been so colossally and uniformly bad that the Fed’s forecast and probability scenarios for the rest of the year seem to range from really bad to God awful.
Broadly, staff forecast seems likely to put the first quarter US growth at a minus 3% and mark down a second quarter collapse in economic activity around a negative 25%, with unemployment soaring to Great Depression levels of between 20% to 30%. Even a more upbeat scenario only has unemployment by year-end clawing its way back from Great Depression levels down to perhaps 10-12%, or the worst of the 2008-2009 Great Recession.
The recent oil price collapse will also weigh down the growth prospects with a devastating hit to the energy sector and for the banks and holders of energy sector debt. And it will not only be a further drag on economic activity, but it will be significantly deflationary in the near term, while the offsetting boost to disposable spending in lower gasoline prices will be limited and slow to kick in.
But perhaps more to point, the uncertainties are so numerous — the very definition of “Knightian Uncertainty” — that the fan charts around a base case are so unusually wide and skewed to the downside that they could be described as “windmill charts.”
So because there is likely to be limited accuracy in traditional point estimates, research staff are rounding out the data and forecasting materials for the FOMC with broad, “probability-based” scenarios for the track of the economy, keying off the potential progression of the virus, and drawing on rapidly assembled anecdotal evidence from large and small business contacts, university medical research staff, farmers, or non-profits working with the poor or out of work to round out the horrible data.
The scenarios are based around a working assumption a rolling “reopening” of the economy will start in May and that it will expand by sectors, or states and regions across the country through the summer. In some sense, the Fed will also be watching the earliest signs of what happens in Asia and Europe as those regions venture into preliminary openings.
There is considerable caution in assuming anything resembling a “snapback” in consumer spending in the second half of the year, for the task is not only about getting people back into employment again, but prodding consumers to spend again — which they will be reluctant to do, much less return to work or use crowded public transportation, if they still feel unsafe or the schools are not fully open.
That translates into a likely higher propensity to save, and the absence of a sustained return of aggregate demand or exports, capital spending, especially across the utterly devastated energy sector, is likewise going to reinforce a cautious rebound at best. Slower, tentative demand growth is almost a given.
What’s more, hanging over the expectations for the second half of this year, the perhaps paramount concern is for a stop/start “accordion effect “of the re-openings leading to a second or successive waves of infections, undercutting the best case for a sustained positive growth in the second half of the year and into 2021.
The stresses in financial markets are likewise unlikely to be fully abated in the second half of the year, and perhaps not until the pandemic is in the rearview mirror. The term sheets of the current mix of 13-3 facilities have a stop lending date of September 30, but they can be extended, and most, if not all, will almost certainly be extended into 2021.
As Chairman Powell made a point to stress in his recent remarks at Brookings, there is literally no limit to the Fed’s liquidity and market functioning measures, as long as the “unusual and exigent conditions” remain, Treasury continues to authorize the Fed measures, and Congress provides the funding, all of which are near certain.
Indeed, there feels to be a resignation or sense of realism of sorts across the Fed system that, even with massive fiscal spending and highly accommodative monetary policy, it may well be years, not months, for the economy to get back to where it was in February.
The Transition from Credit Policy to Monetary Policy
With so much focus on the ongoing crisis management to ensure market functioning, we would be surprised if the FOMC will be addressing the details yet of how the central bank will transition from its current credit policies to monetary policy and a recession fighting strategy to support a sustained return to mandate-consistent levels of inflation and unemployment.
Chairman Powell will almost certainly get questions on policy going forward in the post-meeting presser, but we think that aside from perhaps his laying out broad principles, a more detailed and mapped out monetary policy strategy is more likely to be unveiled at the June meeting, albeit with plenty of speeches and briefings in the run up to ensure it is well telegraphed.
A broad template entailing two key planks is already in place: the first is a very aggressive “lower for longer” forward guidance on rates. Set against the current depth of the collapse in economic activity, the surge in unemployment, and the scale of deflationary pressures coming out of the second quarter, the lower for longer rates guidance is likely to stay in place for years.
And to reinforce its impact, we believe the forward rates guidance will be framed with an update to the Numerical Thresholds that were adopted in December 2012, in this case, an intention to keep rates unchanged until inflation is returning to its symmetrical 2% inflation target with a safeguard threshold of unemployment returning to the Committee’s consensus estimates of its longer run levels.
The main muscle of the rates guidance will again need to come through the balance sheet and large-scale asset purchases.
There is a potentially tricky transition from the current asset purchases to provide broad dollar liquidity to ease stresses in the capital markets to a regime of asset purchases to reinforce the monetary policy ambitions. But there is no particular reason for a stop/start to asset purchases, and the transition to larger scaled up asset purchases could be relatively seamless if well telegraphed and linked tightly to the forward rates guidance.
The need to unveil a new monetary policy framework may become pressing further into the second half of this year as the obstacles to growth transition from liquidity shortfalls or capital market stresses to contending with problems more to do with insolvencies or bankruptcies and helping to support spending and business/consumer confidence.
Nevertheless, all sorts of details will still need to be fully worked out before the new framework is unveiled, which is why we think June would be the earliest possible meeting to unveil the new framework: what should be selected as the main threshold, for instance, nearing the 2% inflation target or building in a tolerated overshoot, or should escape clauses be included if, say, financial stability looks to becoming at risk, or inflation expectations look to becoming excessively unmoored?
Likewise, the Fed will need to get a sense for how large scale the asset purchase will need to be: judging by how far the climb back to 2% inflation and maximum employment is likely to be, there seems to be a working assumption that as much as $250 billion per quarter, or $1 trillion annually in asset purchases, will be needed to provide the degree of monetary accommodation envisioned.
What’s more, if the Fed is bracing for five or more years of $1 trillion LSAPs, it will want to carefully work out in advance its exit strategy and to be sure to only make promises and guarantees it won’t come to regret down the road, and perhaps under a new FOMC.
A Longer Transition to Yield Curve Caps
It is that last point, the path of least regret, which is a key reason we sense the FOMC is for now reluctant to embrace a transition to building its potential asset purchases around capping the yield curve, either at the short end up to two years, or right across the entire curve as the Fed did during the Second World War, when the debt markets were far simpler and easier to guide.
It is not a coincidence there have been so many Fed research papers recently looking at the yield curve policies during the war, and more specifically, the bumpy exit in the run up to the 1951 Accord.
Yield curve caps will be complicated and tricky, and more to the point, are not seen as all that necessary in the near term: the pace of recovery is not really going to be determined by whether the two-year or ten-year treasuries are much above current levels, and the supply of new Treasury debt issuance isn’t showing signs of swamping market demand, at least not yet. And trying to compress yields at this stage could even be counterproductive to groping towards market stability down the road.
Most of all, as we understand, the Fed will want to see the scale of the federal borrowing requirements over the coming years, if not decade, the ability of the markets to absorb the huge supply, its impact in steepening the yield curve, and how quickly it steepens, and if a too rapid repricing threatens an undesired tightening in financial conditions.
There has been no small amount of speculation in the markets in recent weeks over a near introduction of yield curve caps (including a mention of our own, see SGH 3/19/20, “Fed: Yield Curve Caps and Other Measures”). But in the weeks before the pre-meeting blackout, our sense is that in contrast to the potential loss of control over the balance sheet that yield curve management would entail, the simplicity and flexibility of an updated version of an open-ended QE3 looks far more attractive to the Fed in the near term.