While It is striking how disciplined Federal Reserve officials have been in recent weeks, from Chairman Jerome Powell right down across the ranks of the Federal Open Market Committee, in signaling so little on what they are most likely to do with balance sheet policy at the FOMC December 15-16 meeting.
That will change with the release of the November meeting Minutes this coming Wednesday:
*** The market may be hoping for a December extension in the weighted average maturities of the current $80 billion a month in treasury purchases, but we would caution the Minutes are more likely than not to indicate a fairly wide Committee debate and reluctance over the timing and efficacy of such a shift in balance sheet policy. Our sense is that the FOMC may view QE to be less suited to counter a near term pocket of extended weakness relative to what could be a powerful rebound as soon as spring next year. While the Minutes will not necessarily preclude a shift to a WAM at the December meeting, we think it alters the probabilities to no more than even. ***
*** On balance, our sense is that the FOMC is leaning towards a language-only change on balance sheet policy, to align a firmer commitment on the current purchases with the new rates guidance, albeit probably focused on a “full employment” threshold rather than the three-layered inflation threshold guiding rates policy. Taking a near term tapering of asset purchases off the table may be argued as enough additional accommodation until there is clearer picture of fiscal policy and the availability of the Covid vaccine; that, in turn, could point to early next spring for utilizing the balance sheet to dampen a “premature” or excessive tightening of financial conditions. ***
*** It has to be said, however, the December meeting is still three weeks away, a lifetime amid the political uncertainties of raging Covid infections, a still stalled fiscal policy, the lack of political concession on the elections, and the shock Treasury withdrawal of most of the Fed’s 13-3 facilities. The political and market pressures on the FOMC to do “something” could prove overwhelming, and glimpses of what could still prove to be the winning argument within the FOMC to move sooner rather than later on a WAM shift in December may show up in the Minutes as a “pre-emptive” accommodation with an eye on a vaccine-injected burst of repressed spending. ***
Indeed, our sense is that the more likely there is a stronger and sustained fiscal policy, and the greater the likelihood of a widely distributed Covid-vaccine, it will be the prospect of growth, not weakness, that lifts the probabilities and brings forward the timing for the FOMC’s promised pivot to monetary policy and the expected shift in the balance sheet policy.
The Likely Contours of the QE Debate
The first thing that has to be said about the Minutes is that the debate over QE, which is where the market is almost exclusively focused, took place three weeks ago, and all the fiscal and political twists and turns since then are making the eventual FOMC decision on its balance sheet even more finely balanced than usual.
At minimum, it is again putting more of a premium than ever on maximum policy flexibility the week of the meeting. That optionality is one reason we suspect FOMC members have been so unusually disciplined in their reluctance to show their hand until they absolutely need to better frame market expectations.
To be clear, most if not all Fed officials still retain a firm conviction in the muscular potency of balance sheet policy, when rates are constrained by the Effective Lower Bound, to push any needed accommodation into the real economy. That is true whether it is through a lower probability increase in the total of monthly purchases or the more favored shift in the maturities of the treasury purchases to the longer end.
Chairman Powell and Vice Chairman Richard Clarida in fact went out of their way in recent remarks to list WAM as an option on the table – and Clarida in a recent speech even put an “all” in italics for emphasis in affirming that policy options include balance sheet changes. And there has always been an intention as early as the September meeting to follow the adoption of the new framework and its lower for longer rates guidance with a second stage of the promised pivot “from stabilization to monetary policy” as soon as the December meeting (see SGH 9/3/20, “Fed: On September’s Guidance and QE”).
But both the Chair and Vice Chair, as well as most of other Committee members, have also noted the current asset purchases, even across the curve to match Treasury issuance, are not only ensuring market function as intended, but they are already removing a lot of duration, providing about as much accommodation to the economy as that of the QE3 in its peak period in 2013. It is a point we suspect will show up in the staff briefings in the Minutes.
And what’s more, while most Fed officials are sticking to the narrative of how solid the banks are and how they weathered the storms of March, there is still a nagging doubt among many in the Committee over using QE that may only serve to stir the risks of greater leverage and excesses in the financial markets in the hopes of limited accommodation into the real economy with yields still so low.
In the meantime, though by no means a Committee consensus yet, the thinking is that a “bridge” of new language guidance in December that reaffirms there is no chance of a tapering in the current asset purchases until the labor market is approaching an admittedly still loosely defined “full employment” should be enough accommodation until there is the valued clarity on fiscal policy and the Covid vaccine.
QE’s Purpose and Timing
We think then that the debate in both the Minutes and around the table in December will not be really be about the potential efficacy in a shift in balance sheet policy – it is not in doubt — but over its purpose and timing.
It is not a near term weakening in growth that will necessarily dictate the FOMC’s decision on QE; they have and will keep emphasizing that fiscal, not monetary, policy — the spending not lending mantra — is the appropriate and more effective policy response to an emerging base case Fed forecast for near term economic weakness, perhaps through the first quarter of next year, but potentially longer.
But we think Fed officials believe the higher probability need for monetary policy is for it to be calibrated relative to the rising probabilities of both a Biden Administration/Democratic House-driven pick up in fiscal spending as soon as the first or second quarter next year, if needed, and right through the FY2022 budget beginning next October. Even more powerfully, the repressed spending of this year may give way to a trillion dollar-plus burst of spending and hopefully business investments once a credible and widely distributed vaccine becomes available.
That is pointing to the early spring when we think the FOMC envisions bringing to bear the full powers of the balance sheet in asset purchases heavily weighted to the longer end. Monetary policy would then be stepped up to dampen the eventual rise in yields on the back of credible and positive fiscal and vaccine news. In doing so, it extends the period of accommodation in order to ensure the run to full employment and the eventual overshoot of the 2% inflation target.
A ”Pre-emptive” Option In December
Since many if not most Committee members have repeatedly affirmed their being quite content with the current degree of accommodation, that yields if anything are probably too low or hardly slowing demand, it raises the question of why so much of the market remains convinced of a WAM announcement at the December meeting. If the FOMC is indeed wanting some policy room in December, we are likely to see a ramping up in their messaging after the Thanksgiving break in the run up to the pre-December meeting blackout. Adding to the potential volatility of policy messaging, that that starts the day after the December 11 deadline for the FY2021 Continuing Resolution .
We suspect the markets are hearing what markets want to hear, but it is also a very real learned response that the track record of the Fed has been to avoid surprising the market with anything that could even remotely be taken as hawkish relative to entrenched expectations. And not to put too fine a point on it, but Chairman Powell and his voting colleagues on the Committee will wish to avoid a redux of the December 2018 “auto pilot” balance sheet gaffe.
On that score, we suspect that one argument that may show up in the Minutes, and which could still prevail at the December meeting, is the merits of a pre-emptive accommodative shift in the balance sheet stance to get ahead of a sharp or even severe steepening in the yield curve; after all, the market may keep surging on more good news on the Covid vaccine.
And even though Vice Chairman Clarida said he was not all that concerned by the pop in yields a few weeks ago on the first reports of vaccine breakthroughs, that stance may be pushed to the side if the vaccine news provides a Christmas season boost to confidence and spending.