A few points on what we think will be the most likely takeaways this coming Wednesday afternoon when the Federal Open Market Committee wraps up its two-day September meeting:
** First, so we don’t bury the lede, we do not believe there will be any adjustments in the amount or maturities of the current $80 billion a month in treasury purchases this week. A Committee majority seem perfectly happy with the current policy guidance, and we would take at their word the half dozen or more Committee members who went out of their way in the week before the pre-meeting blackout to lower expectations for a burst of new accommodation this week, none of which saw any pushback or correction from Chairman Jerome Powell in his closing remarks to the week in his lengthy NPR interview.
** Instead, we think the September meeting will mark the first of what is likely to be at least a two-step transition from “stabilization to monetary policy.” This week will largely revolve around aligning the post-meeting statement with the language of the “Statement on Longer-Run Strategy and Monetary Policy,” namely replacing the current symmetric inflation language with the new “average” 2% inflation “over time,” as well as putting inflation expectations at the center of the new inflation ambitions; likewise the FOMC is likely to note how “maximum employment” has been redefined, perhaps by clarifying the dovish distinction between “shortfalls” versus “deviations’ in the unemployment mandate.
** And while we do not anticipate a change in the QE totals or duration to longer term purchases, we would not be surprised if the Committee sought to avoid any potential balance sheet messaging mishap by adding a clause or phrasing to the current QE guidance: indicating there will no reduction in the current treasury purchases, for instance, or extending the meaning of “coming months” beyond the turn of the year, or that the pace or maturities of treasury purchases can be adjusted as needed. An added emphasis that the current QE purchases helps to support a stronger economic recovery would do no harm.
** A more muscular second stage in the transition to monetary policy would then comprise the widely anticipated changes with the more explicit and aggressive forward rates policy guidance tethering a lagged start to rate hikes to outcome-based thresholds or a single threshold, and a reinforcing balance sheet policy that is most likely to initially come with either additional or current treasury purchases weighted to the longer end.
** This second stage could come as soon as the December meeting, but depending on the economic outlook and financial conditions, it could still come after the turn of the year. Presumably, while it can’t be ruled out, the November meeting, just days after the presidential elections, whose results may or may not be immediately clear, is probably not an ideal moment for a major shift in monetary policy. We also do not entirely rule out the adoption of yield curve caps at a later stage of a still evolving implementation of the new monetary policy framework.
** As we have previously noted (see SGH, 9/3/20, “Fed: On September’s Guidance and QE”), we think the need for the pivot to monetary policy to come in stages is primarily due to the early stage of the Committee discussions to reach a consensus on the construction of outcome-based thresholds or a single threshold (which a majority of the committee seems to clearly favor over a calendar-contingent threshold), as well as the balance sheet policy options, and potentially, how financial stability considerations may enter into the policy calculations over the medium term. Those discussions may be threads of debate running across several meetings, so we would be shocked if all of the details to these issues could be wrapped up and unveiled this week.
** And in any case, on a more basic level, the FOMC would clearly feel far more comfortable deciding on the degree of accommodation needed in the real economy, and its optimal transmission when constrained by the Zero Lower Bound, when they have a better grasp of crucial uncertainties hanging over the forecast; the progression of the virus, the course of the health care response, and delayed fiscal policies are putting unusually wide confidence bands around forecast point estimates and weighting the forecasts towards downside risks.
** Some of that, as well as a potential reinforcement to the current policy guidance may become apparent in the quarterly Summary of Economic Projections and the rate dot plots, especially in their being extended out to 2023. For one, the rate dot projections are all but certain to remain flat as a pancake, validating the market pricing for a highly accommodative, lagged Fed reaction function for what is highly likely to be years to come.
** It will be especially noteworthy, and interesting, to see whether a few Committee members still pencil in an initial lift-off in rates from the ZLB rate in 2023 – we recall two members did for 2022 in June — but in light of the new framework displacement of the Phillips Curve trade-offs in favor of a more inflation expectations primacy to the inflation formation process, it may prove difficult to mark the start to rate hikes into the assumed appropriate rate policy path. After all, by definition, marking a rate move, even if three years down the road, is still tantamount to “thinking about thinking about rate hikes,” which suggests a solid Committee majority will be sticking to an unchanging median rate dot plot.
** We were also initially thinking a handful of Committee members might pencil in an overshoot of the 2% mark by 2023, especially if rates remain pinned to the ZLB over the entire arc of the forecasting horizon. But once anything but an extremely flat Phillips Curve is stripped out of their forecasting models, it may prove difficult to get the numbers to work up to an overshoot, even by 2023. At the same time, should there be more than a handful of Committee members marking in an inflation overshoot in 2023, say, 2.1% or 2.2%, it may offer an initial, even elegant, guide to defining how much of an inflation overshoot is tolerable.
** Otherwise, the 2020 growth forecasts are all but certain to be improved from June’s -6.5% year-end projection, with some momentum carrying over into 2021, while the median headline unemployment will likewise be lower and healthier looking than June’s 9.3% median estimate. Indeed, that better than expected labor market rebound brings to mind the Fed’s labor market projections were similarly underestimating the gains during the 2015-2018 policy normalization period. And there is still an upside surprise the staff projections will have to incorporate into their forecasts – an early vaccine for instance would undoubtedly trigger a swell of spending.
** But the primary takeaway from any better than expected near term rebound will be more than offset by the projections further out the forecasting horizon that are likely to reflect a Committee consensus the greater probability is for a recovery that will slow and flatten out from here.
** The base case, when uncertainty invariably translates into cautionary savings and lower investment spending, will be of an economy at risk of entering a more “conventional” recession dynamic of extended longer term unemployment, pressures on the female labor participation rate, and a still to come wave of insolvencies, small business bankruptcies, housing evictions, and large-scale state and municipal lay-offs if fiscal policy in particular is not stepped up to plug the hole in aggregate demand still left from the spring stop to spending.
** Chairman Powell’s messaging at the post meeting presser will not necessarily be so bleak, but he will be clear in warning the recovery is likely to get harder from here. And he is very likely to be even more vocal about the pressing need for Congress to step up on fiscal policy, even declaring a gridlocked failure to pass any phase IV spending the single gravest threat to the recovery.
** And if truth be told, he would add that the lack of fiscal support is also undermining the Fed’s hopes of achieving its twin mandates without undertaking such a prolonged period of easing that it risks creating imbalances that invariably show up in financial market excesses and instabilities long before any success in lifting inflation and a more a balanced growth.
** It is why we think Chairman Powell will also be stressing an essential need for policy flexibility going forward, and how he manages to reconcile that need with the conviction and credibility needed to shift market and public expectations will be the true testing of the Fed’s new framework in the months ahead.