Fed: Until the Economy Says No

Published on January 8, 2021

As the US economy pulls away from the debris of the Covid-ravaged turn of the year and the political chaos of the final weeks of the Trump presidency, we think the dominant driver to market and economic developments this year and next will be the scope and scale of shared monetary and fiscal policy objectives between the Federal Reserve and the incoming Biden Administration.

*** As we previewed late last year (SGH 12/1/21, “Fed: The Yellen-Powell Nexus”), 2021 will mark a rare convergence of an aggressive, multi-phased fiscal policy underpinned by a highly accommodative monetary policy. Indeed, in an echo of the policy coordination of the 1960s “New Economics,” we expect the Fed will lend its support to Treasury and Congress with the ambition to create a “high pressure economy” that spurs a faster jobs and wage growth. That, in turn, could boost trend growth and even begin to lift r* assumptions, reversing some of its long secular decline.***

*** In terms of the Fed’s policy path this year, two aspects stand out: the first is how balance sheet policy will be adapted to maintain a highly accommodative support to the lead of fiscal policy. Our base case is that a shift in the weighted average maturity of asset purchases to the longer end, coupled to a one-off reduction in the monthly total of asset purchases, could be set in motion as soon as the June but probably September Federal Open Market Committee meetings, with the much-discussed tapering of the asset purchases then coming much later, probably next year. ***

*** A second key issue, even if it is assumed to be some distance on the policy horizon, is how much of an overshoot of the 2% inflation target will eventually be tolerated, if not welcomed. The “intrinsic dynamics of inflation” still look to be quite inertial and slow moving. And that translates, for now, into an accommodative monetary policy to bolster fiscal policy that will be pursued until the economy says no, that is to say, until inflation threatens a momentum taking it north of the previous 2.5% inflation safeguard of the 2012 QE3 Numerical Thresholds. ***

The Fiscal Policy Lead

Fed officials warmly welcomed the $900 billion Covid relief bill that was passed just before the Christmas break as a badly needed bridge of income support to get the economy and those hurting through what is going to be a pretty bleak first few months of the year.

The alarming increases in Covid infections and renewed lockdowns will already weigh on the first quarter economic activity. This morning’s dismal non-farm payrolls print is a testimony to that derailment of economic activity, and it will only add to the political momentum for further fiscal support to the economy.

Indeed, that backdrop of need, coupled to the surprise, albeit slim, Democratic control of the Senate after the shock twin victories in the Georgia Senate run-off elections, sharply boost the prospects for further fiscal support: for one, another supplementary Covid relief fiscal bill early in the Biden Administration seems near certain, with its size in the $500 billion to $600 billion range, with much of it directed to state and municipal government support that could come by March.

But the far more important and pivotal fiscal initiatives will be in the FY2022 budget that will get underway in the return to regular order starting in the House, and especially in an additional, ambitious multi-trillion dollar infrastructure and tax package now possible through reconciliation. That is perhaps the key outcome to Senate Majority Leader Chuck Schumer’s new control of the Senate legislative agenda and floor, while a trio of liberal Democrats would assume the  chairmanships of the Senate Banking, Finance, and the Budget Committees under Ohio’s Sherrod Brown, Oregon’s Ron Wyden, and Vermont’s Bernie Sanders respectively.

It is worth noting that these fiscal ambitions, which should come into focus by March, if enacted, will be adding to demand and job growth in the second half of this year and into 2022. This stimulus, aimed at addressing long standing structural shortfalls on infrastructure, education, and income distribution, will come on top of the widely expected rebound in economic activity in the second half of the year – assuming of course that the mass vaccinations allow for a return to a resemblance of “normalcy.”

And a Supportive Monetary Policy

As we noted, the scale of the Biden Administration’s fiscal ambitions through reconciliation should come into view by March, and that will be equally important to driving the timeline to any near term changes in the Fed’s supportive balance sheet policies. A couple of points on that:

Current monetary policy under the new policy framework, mapped out in the guidance on rates since September and December’s alignment of the guidance on the central bank’s $120 billion in treasury and mortgage purchases, is already highly accommodative and keeping financial conditions remarkably easy.

That was one reason why we were so skeptical the FOMC would add further accommodation by changing the average weighting of its current asset purchases in December, namely, why bother? (see SGH 12/9/20, “Fed: December Preview” and going back further, SGH 11/23/20, “Fed: The Minutes and the December Meeting”).

It is likewise important to note that conceptually, our sense has always been that the purpose of the Fed’s accommodation going forward is not to press yields lower ala QE2 and QE3 – they are already low – but potentially to dampen any premature rise in real yields or tightening in financial conditions and thus extend a period of accommodation for maximum support to fiscal policy (SGH 12/16/20, “Fed: The Hippocratic Meeting”).

The fiscal policy lead that will come into a clearer view by spring is critical to the transmission of that intended easing because a massive monetary accommodation alone would probably not spur enough demand or elevate inflation expectations without potentially costly financial stability trade-offs. And depending on how the economy progresses, and financial conditions evolve, there may be no need for additional accommodation at all.

The variances around the forecast for this year are still wide, even if the risks to the outlook are more balanced and even tilted to the upside by the second half. That is all the more reason that before pulling the trigger on any change to their balance sheet policy, Fed officials want greater clarity on the progress of the mutating virus and the mass vaccinations, and especially on the scale of the fiscal policy that will begin to take shape this spring.

That need for clarity — and at least an implicit coordination or understanding with Treasury – we think pushes any potential change in Fed balance sheet policy out of the March meeting and into the June meeting at the earliest, or even more likely the September meeting, to allow for plenty of messaging runway.

Only a very rapid and sustained tightening in financial conditions, or volatility at the front end of the curve that would suggest market doubts on the credibility of the Fed’s current forward guidance would change the strong preference to wait until the summer before making any balance sheet decision.

A Two-Step Taper

One last point is that our sense is that Fed officials are somewhat uncomfortable with the current scale of the $120 billion a month in treasury and mortgage purchases, which is reflected in the somewhat premature public discussions over whether or when to begin tapering the asset purchases.

We for now suspect the most likely policy recourse will be a coupling of any additional easing through weighting the purchases to the longer end with a run off of bill and short paper purchases, or even an Average Maturity Extension program that brings the monthly purchases down to $80 or $90 billion going forward. A further tapering of the purchases would then come later as the qualitative judgement of “substantial further progress” is made on the employment and inflation thresholds.

We would caution, however, there is no Committee consensus yet on either the timing or shape of the balance sheet policy later this year. That is one reason Committee members are more or less free until there is a policy consensus to offer their views on whether and when and how to taper asset purchases.

Until then, the premium is on maximum balance sheet policy flexibility and keeping those options open until probably the summer.


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