Four key points stand out to us in the wake of Federal Reserve Chairman Jerome Powell’s 60 Minutes interview on Sunday, his comments last Wednesday to the Peterson Institute for International Economics, and in looking ahead to today’s testimony with Treasury Secretary Steven Mnuchin before the Senate Banking Committee and the release of the Minutes to the Federal Open Market Committee’s April meeting on Wednesday.
*** First, is that Chairman Powell’s repeated pleas with Congress to keep the fiscal taps open underscores what we think is fast becoming the Fed’s unspoken future dependence on fiscal policy to take the lead if the central bank is ever going to achieve either of its twin mandates any time soon. That, in turn, will become a key driver in the Fed’s internal debate over the “how and when’ to the eventual transition from its present credit policies to ensure market functioning to what will be a highly accommodative monetary policy at the Zero Lower Bound to underpin a sustained economic recovery. ***
*** Second, it feels unlikely to us the Federal Open Market Committee will be unveiling its revised Monetary Policy Framework Review at the June meeting as previously intended. They still could, and the FOMC had largely reached agreement on an aggressive “lower for longer” forward guidance, framed by thresholds on employment and inflation, before the “monkey wrench” of the COVID-19 crisis. But, on balance, we do not have a sense of a Committee consensus yet on the balance sheet policy when rates are likely to be pressed for so long at the ZLB and, which we suspect, is moving towards an eventual embrace of some form of yield curve management. ***
*** Third, we suspect Fed officials are debating whether an “intermediate phase” may be necessary before a new framework can be mapped out. That may entail an extended “steady state” period of, say, $5 billion a day in treasury purchases to ensure market function, but which could be flexibly adjusted up or down if US Treasury debt issuance excessively steepens the curve. In that sense, the slowing pace in treasury purchases to a “mere” $6 billion a day is a cautious probing to find the right balance, drawing on the lessons from last year when the reduction in reserve balances overshot an optimal equilibrium level. ***
*** And finally, two other points color our sense of the Fed’s evolving policy stance: that if this intermediate phase should play out, perhaps through the summer, it would be to encourage a cleaner market price discovery, whose erosion was a concern implicitly threaded through last week’s Financial Stability Report. And to calm markets, whose future appetite for treasuries may depend on the reassurance of the Fed as buyer of last resort, the FOMC may turn to issuing a general “Principles and Plans” statement to affirm progress towards the timing and scale to future asset purchases, just as it did in the run up to its Policy Normalization strategy launched in 2015. ***
“Forcefully, Proactively, and Aggressively”
After his previous repeated vows the Fed will act “forcefully, proactively, and aggressively,” Chairman Powell delivered more of the same in both his PIIE and 60 Minutes interviews, deftly in batting away the chatter on negative interest rates, laying out a somber, more realistic outlook for a better second half of this year – “assuming there is not a second wave of the coronavirus,” a rather substantial caveat — and flagging a lengthy path to a recovery to the end of next year, with the question over whether the third quarter this year will carry a positive or negative sign being a “key question.”
And Chairman Powell again pressed his case for an aggressive fiscal policy response to the crisis, including a hat tip to additional federal assistance to the state and municipal governments in order to avoid longer-run damage to the economy.
But the key takeaway for us was when Chairman Powell finally made a reference to monetary policy, which to date he and other Fed officials have simply tossed to the side by affirming they are happy where it is. After repeating the mantra that the Fed is neither “out of ammunition” nor is there “any limit to what we can do,” Powell noted “there are things we can do in monetary policy. There are a number of dimensions where we can move to make policy even more accommodative. Through forward guidance, we can change our asset purchase strategy. There are just a lot of things that we can do.”
To date, the Fed has been in no hurry to map out much less begin implementing its monetary policy plans, mostly because the economy is still in its nosedive stage and the financial markets are only just now starting to stabilize, so there isn’t much transmission to speak of at present from the monetary accommodation already undertaken. The Fed’s ambitions to date, in fact, have largely been to prevent a negative transmission of the dislocations and stresses in the capital markets to the real economy; thus its focus on the massive expansion of QE that distributes liquidity broadly, and on its nine and counting 13-3 credit facilities.
Indeed, when credit begins to rise on a more sustained and broader basis, and aggregate demand begins to pick up, that is the signal in real time that the monetary policy accommodation already “prepositioned” in the March rate cuts and balance sheet expansion is beginning to be transmitted into the real economy.
In other words, it is not the quantity of asset purchases but their impact in the real economy that will define the distinction between large-scale asset purchase to ensure market function and the more familiar QE to provide accommodation to support economic recovery.
The Policy Framework Review
In the year-long work right up to the eve of the Great Lockdown, Fed staff and the FOMC had been working on revisions to its policy framework to address the “challenge of our time” as Powell put it, in the persistence of low inflation and the undershooting of the 2% inflation target practically ever since the day it was adopted in 2012 and which threatens to entrench a slow deterioration in inflation expectations.
It must be frustrating that the upheavals of the COVID crisis upended much of their work, but we understand that after more than a year of staff work, Fedspeak sessions across the Districts, outside research papers, and extensive Committee deliberations, the FOMC has pretty much reached a consensus on the “constitutional document” of its annual “Statement on Longer-Run Goals and Monetary Policy Strategy” that was delayed from its usual updating every January to what was intended to be the unveiling of its revised language at the June FOMC meeting.
It may seem like small ball stuff set against the magnitude of the wrenching devastation of the COVID crisis, but the changes to the policy framework look to have been built largely around language changes to the phrasing on the inflation mandate, to enshrine a lower for longer policy messaging with language along the lines of aiming to achieve an average 2% inflation rate over the life of a business cycle.
To add some heft to the guidance, the lower for longer rates vow would be tethered to real economy thresholds for a sustained rise in inflation back to or overshooting its 2% target, and for a return in employment back to its estimated longer run levels. But in the current environment, there are few, if any, who don’t already doubt rates will be lower for longer.
Balance Sheet Complications
The FOMC may still opt to release the revisions to the longer run statement, whose language would then be put into the meeting’s formal statement to replace the guidance language adopted in March. But it may have little immediate impact if they do, because the issue with the most immediate and substantial influence on market expectations and pricing is what the Fed will do with the balance sheet and its plans for large scale asset purchases. That decision could become quite complicated and may not allow for quick decisions within the next few weeks.
In the prior QE programs, the transmission of accommodation when rates were at the ZLB was primarily through the “portfolio rebalancing channel” to drive longer term yields and the term premium lower and taking duration out of the market. But yields are already low and there is no term premium to speak of, so what exactly would the point of QE be, if yields are already pancaked and, if anything, looking a little too flat rather than too steep?
The point to future QE purchases, in that environment, may be a flipside to the QE past: the aim is not to push yields lower, but to cap them from going too high or too fast that it prematurely threatens to end the needed maximum accommodation to ensure sustained recovery and stoke higher inflation expectations. And that, of course, is pointing to yield curve caps of some sort, with all the design decisions that would entail, not to mention the potential loss of control over the size of the balance sheet.
Fed officials will want to be very careful before making a commitment on that scale, and at minimum they would need to get a far better feel for the scale of federal spending in a medium term framework, and probably a better understanding on the respective roles, or even a new “Accord” with Treasury to more efficiently coordinate debt issuance and asset purchase strategies.
Fed officials are very aware, painfully aware, that they will need to telegraph their new monetary policy strategy at the zero lower bound well before the economy is picking up momentum in order to maximize the potency of its forward guidance to temper the pace of any steepening in the treasury yield curve or widening in credit spreads that would translate into a premature tightening of financial conditions.
With rates where they are, they have some time to work out their revised strategy at the Zero Lower Bound, but the clock is ticking.