With the Federal Open Market Committee’s milestone September meeting in the rear view mirror, Fed officials will be hitting the zoomed airwaves this week to pitch the policy takeaways of the new framework, starting with three high profile House and Senate testimonies by Chairman Jerome Powell. Vice Chairman for Banking Supervision Randall Quarles will also be weighing in along with a near dozen speeches and public remarks by other FOMC members.
Before that gets underway, we would make three points on the still unfinished business in the Fed’s promised transition from stabilization to monetary policy, which we think is likely to shape the messaging and market pricing over “the coming period,” to borrow a phrase:
*** First and foremost, the primary intended messaging takeaway likely to run through testimony and speeches alike will be a lofty emphasis on how forcefully committed the Fed will be to an extremely dovish reaction function going forward. A key objective of the Committee was to enshrine the new consensus “flexible average inflation targeting” and redefined “maximum employment” of the longer run statement into the September post-meeting policy statement, and on that they mostly succeeded. Even the rate dot plots, in being mostly flat right through 2023, were supportive this time that a long period of essentially negative real rates are be on the near horizon, even as the economic rebound gathers momentum. ***
*** The smoothness of that messaging, however, is near certain to run into turbulence, on two counts: the first is the tension between the desire for discretion and policy flexibility in light of the unusually wide variance over the near economic outlook, versus the demands of a rule-based credibility to reinforce the commitment to the more dovish reaction function; the other looms even larger, that the market has already fully priced in the “powerful” rate forward guidance, and remains more rattled by what wasn’t on offer last week, namely, the lack of clarity on the scope and scale of the Fed’s balance sheet policies that would put some muscle behind the talk.***
*** But as we wrote previously (SGH, 9/3/20, “Fed: On September’s Guidance and QE”), our sense was that the FOMC would not be ready, or able, to commit to changes in its balance sheet policies at the September meeting. Short term fixes could come through liquidity operations if financial conditions tighten prematurely. But we understand that before going to the “next stage” of the pivot to monetary policy. the Fed is seeking a clearer sense of fiscal policy and the outlook, but more fundamentally, it is reviewing the efficacy of asset purchases and looking into all the potential channels of balance sheet transmission, their potential effects on bank lending constraints, as well as possible effects on financial stability. ***
Flexibility versus Commitment
The debate over rules versus discretion is perhaps one of the longest running themes in monetary academic theory, and the issue lies at the heart of the FOMC’s first stab at adapting its first post meeting policy statement to the new policy framework enshrined in the revised “Statement of Longer Run Goals and Monetary Strategy” that was released at Jackson Hole in late August.
To be fair, it was no mean feat to first forge a consensus on the longer run statement, and to then shoehorn its strategic meaning into a tactical execution in the language of the first post-meeting statement a few weeks later. The statement’s forward guidance, meant to signal an extended period of essentially negative real policy rates for the next few years, was even stronger than what might have been expected, in that it tethered the lower for longer rates to outcome-based thresholds on both inflation and employment.
But if truth be told, the statement’s guidance sentences were a bit awkwardly phrased: rates won’t be lifted until inflation hits the measured 2% mark as expected, but the guidance also seemed to include additional thresholds of a forecast-sounding “on track” to both “moderately” overshooting the inflation target and apparently also needing to hit an undefined maximum employment.
Chairman Powell asserted in his presser that the new “powerful” guidance would be “durable,” suggesting the Committee doesn’t really want to hit the thesaurus again any time soon to fine tune the guidance language. But we suspect its phrasing may still need to be cleaned up in later statements, perhaps at the December meeting, for instance, when the Summary of Economic Projections and the rate dot plots are also due for what could be a significant revamp of the current format.
The Dissent Bookends
But tellingly, while we tend not to be all that bothered by dissents, September’s two dissents did happen to neatly bookend the terms of rules versus discretion fault lines within the Committee. And it could have policy implications down the road when, at some point, the Fed is invariably and inevitably tested by the market doubting its forward guidance.
Federal Reserve Bank of Dallas President Robert Kaplan held out for more flexibility to be reflected in the statement, including a sensitivity to financial stability safeguards of some kind, while Federal Reserve Bank of Minneapolis President Neel Kashkari pressed in the exact opposite direction, arguing for a much cleaner commitment not to move rates until not only the 2% inflation mark is hit, but for a clearer sense of how long after that the rates will stay on hold to lock the Committee into its commitment on the lower for longer rates.
In true Committee fashion, the compromise was to go right down the middle, with the awkwardly phrased language, and of course as many market analysts complained, the decision to take a pass on any detail on the how to get to the promised land of an inflation overshoot and the vaguely defined maximum employment.
But if there was a gun to the head of the other Committee members, we suspect they would tend to sympathize with Kaplan’s desires for maximum policy flexibility.
In the near term, the need is obvious: there are such extremely wide variances around the staff point forecasts on the path of the economy, in no small part due to the uncertainty over fiscal policy or the possible course of the Covid pandemic through the winter months. And unspoken is another enormous uncertainty: the potential for highly volatile, polarized politics around the November elections that could easily and almost certainly spill over into the markets and in flattening consumer confidence and spending.
The FOMC, then, will need to position its policy stance for potentially powerful upside risks – a rebound of a resilient economy that comes tantalizing close to looking like the elusive V, an imminent breakthrough on a vaccine, or an unleashing in a torrent of pent-up spending – as much as it is bracing for a current base case forecast that, even with the September upgrades to growth, is still laden with downside risks.
It is little surprise then that in facing these uncertainties of almost “Knightian” proportions that policy flexibility is the more prized priority for this FOMC than a tightly binding commitment on just what exactly the new reaction function will entail down the road.
“We are not looking at a rule,” Chairman Powell said in the presser last week, perhaps in the hope that such a declarative remark might bring the debate to a close. “We’re looking at a judgmental assessment.”
“The Lady Doth Protest Too Much”
It hasn’t and won’t. Indeed, that tension between flexibility and credibility that ran through the guidance language of the statement is also at the heart of a still evolving balance sheet policy debate, whose complexities go far beyond the market’s singular, almost simplistic, focus on the near size or duration of further asset purchases.
All of that had a lot to do with Chairman Powell’s brave face in last week’s presser in seeking to buy some time by repeatedly stressing — we honestly lost count of how many times — how “strong” the guidance was in his presser; it brought to mind Hamlet’s mom, Queen Gertrude, skeptically suggesting to the doubting prince that “the lady doth protest too much,” and the market’s lackluster reaction in its wake pretty much pointed to the same degree of skepticism.
But buying time will be a valuable commodity in the coming week, if not months. Almost by definition, if rates are off the table for years, then policy moves signaled through the balance sheet are pushed front and center, and there may be a clock on how much time Fed staff and the FOMC can work through the complexities and scenarios over the next step to balance sheet policy.
For example, the Fed’s internal discussions over their balance sheet options will include assessing whether asset purchases will have all that much accommodative benefit relative to their potential costs when the term premium and yields are already so low; more critically, Fed staff are drafting out scenarios to assess the implications of the balance sheet expansion in potentially creating undesirable lending constraints on the commercial banks in pushing yet more excess reserves onto their balance sheets.
There are likewise broader financial stability considerations in the mix. Chairman Powell stressed in the presser last week that he didn’t think “the link between QE and financial stability was a tight one.” But he also tellingly said the “true test” of that is whether a “majority of the Committee feel that monetary policy is triggering that” — which kind of sounded like a minority of the Committee thinks exactly that.
And, that question, of course, is the heart of the matter. Even if financial stability concerns are not at the forefront of the policy deliberations – lending support to a still struggling economy and pushing down unemployment is — we think the staff work on the coming Financial Stability Report due in mid-November, and a planned bank regulation conference in December will be channeled into the eventual decisions on balance sheet policy.
Regulatory and Balance Sheet Tracks
As just one indication of a parallel track underway that adds to the complexities of weighing asset purchase considerations, the Board of Governors and Board staff have been working with a thinly staffed Treasury department and Banking Committee leadership on Capitol Hill on a controversial loosening of the Dodd Frank capital, leverage, and liquidity ratios on the commercial banks.
To a degree, the new thinking on the Dodd Frank safeguards may have originally been ideologically driven with the arrival of a Republican Administration and control of the Senate. But it is our understanding that the events of last September in the repo spike and especially the March market dislocations significantly altered the terms of the balance sheet policy.
Namely, that it took a mind boggling $3.5 trillion of treasury purchase over barely weeks to break the bond market freeze-up dramatically and suddenly fused the debate over balance sheet policy with a parallel regulatory policy push in the possible need to loosen up the bank capital, leverage, and liquidity requirements to ease commercial bank balance sheet constraints and indeed, to rethink potentially unintended consequences over systemic financial stability.
The issue lies in the not too distant future: as the Fed balance sheet expands, it may not be as cost free as it was assumed in the prior rounds of QE, mostly because no one seriously imagined the balance sheet would ever hit $7 trillion, much less go higher still. But under even conservative projections, the size of the balance sheet could rise significantly in an open-ended QE under an outcome-based threshold guidance that could stretch out for years; no wonder Chairman Powell will no doubt again plead for fiscal policy in the hopes the Fed may not need to lean on the balance sheet taps so aggressively.
And while an ongoing expansion of the balance sheet, and scale of the excess reserves pushed onto bank balance sheets to fund the purchases, may not necessarily be pressing issues right now, at some point, potentially as soon as next year, it could be with potentially unforeseen ripple effects that could suggest the expansion of the balance sheet is not as benign as previously assumed. Reliance on stuffing commercial bank balance sheets with excess reserves may have its limits in lending constraints imposed on the commercial banks. That, in turn could force a turn to perhaps an enlarged Treasury General Account or the Foreign Central Bank account on the Fed’s liability side, but both of which would invariably entail negotiations.
The commercial banks hardly ever complained about the prior QE runs of interest-bearing free money, but the level of reserves – especially if an expanded QE is truly open-ended – could rapidly becoming a more real constraint on the banks in potentially “crowding out” low returning assets and limiting some lending, since the reserves are lumped into the regulatory ratios with all the other assets on the banks’ books.
That may have something to do with the letter Vice Chairman Quarles, who oversees the Board’s supervisory functions, wrote last April to Senate Banking Committee Chairman Mike Crapo calling for modifications of section 171 of the Dodd Frank legislation, the so-called Collins amendment, to give the Fed and other regulators greater flexibility in interpreting the leverage requirements demanded of the banks.
Doing so is not without its political controversary, but we bring it up only to underscore the point that we suspect there is far more to the Fed’s current calculations underway in fleshing out a balance sheet policy than simply the assumed mostly benign, “Woodfordian,” reinforcement of the rates forward guidance.
The $120 Billion a Month “Placeholder”
If the clarity on the balance sheet policy is not forthcoming before too long, there are faint echoes of a potential redux of the communications own-goal on the balance sheet that torpedoed the dovish hike of December 2018. We think Chairman Powell and his Committee colleagues will seek to ease market restlessness and anxieties in two ways.
The first will be the reminder that the current $120 billion a month in treasury and MBS purchases are hardly chump change and are as a placeholder until a fuller, final version of balance sheet policy is laid out. It is indeed not only ensuring market function, but it is already providing an awful lot of accommodative support to the economy. Even in March, the huge swell of asset purchases on top of quickly slashing rates to zero entailed a huge pre-positioning of accommodation as the economy gathered traction.
And second, if their hand is forced by market conditions prematurely tightening, the FOMC left itself wiggle room in the “at least” phrasing to the current balance sheet guidance; an FOMC teleconference could be quickly assembled to greenlight the Open Market Desk to step in with repurchase agreements or even additional QE if needed to ensure smooth market function and access to credit.
Finally, as a heads up to the Chairman, we also suspect some Committee Democrats will be pressing him in his twin testimonies on Capitol Hill on potentially supportive balance sheet policies the Fed could undertake to bolster fiscal policy priorities under a Biden Administration, as well as suggestions on the fate of the 13-3 facilities.
Indeed, the voices of the ghosts of some of the FOMC’s since departed institutional hawks, who warned that once the QE door is opened, it may prove difficult if not near impossible to ever close again, may come back to haunt the Powell-led FOMC through the course of their balance sheet deliberations in the coming weeks and months.