Again, as expected, the FOMC kept the fed funds interest rate steady at a lower-band target of 0.00-0.25%. Without dipping into the unchartered and controversial waters of negative rates, this is as far as they can go.
The formal statement remained bleak in tone, with an outlook for growth extremely challenged due to Covid, not to mention global human suffering and loss of employment; however, some improvement at the margin as the result of government stimulus was noted. Their economic projections noted a mid-single digit expected decline of 2020 GDP, with little change expected in fed funds rate policy for the next 2-3 years. Due to the large degree of medical uncertainty, the Fed appears to be focused on providing accommodation as needed to bridge the gap between Covid economic shutdowns and an eventual recovery; although some observers have raised concerns over tipping the balance toward providing too much, keeping interest rates low for too long, and risking asset pricing bubbles or inflation at some point.
It wasn’t mentioned in the formal policy statement, but there has been increasing talk of the Fed turning to a concept called ‘yield curve control’. This sounds elaborate, but it’s essentially a more targeted version of quantitative easing, and is not a new tool. In World War II, the Fed capped short rates at 0.375% (really 3/8%—fractions were used for bond quotes back then) and long rates at 2.5%. This was done to keep borrowing costs down, maintain a positive-sloping yield curve, and set future market expectations. How would this work? The Fed would essentially engineer purchases to cap rates at a certain level. For example, if the 10-year treasury cap was set at 2.0%, if market activity caused rates to drift up toward 2.1%, the Fed would step in, buying bonds, which would drive prices up and yields down. And repeat as needed. If rates fell, however, to 1.8%, it’s debatable whether action would be taken since lower rates could be seen as preferable. This is just one example; it might work differently in practice. Other central banks, such as Japan, have been doing this for many years with mixed reviews. It may provide a way to keep yields down, though, using a more targeted level of new debt as opposed to a ‘shotgun’ approach.
The official indicators remain similar to the last meeting—a complete reversal of conditions earlier in the year:
Economic growth: Beginning with the first signs of strain in March, U.S./global GDP has sunk to levels not seen since the financial crisis of 2008, and by some magnitude, the 1930s Great Depression. The speed of the downturn, brought on by Covid-preemptive shutdowns, has also been unprecedented. The decline in U.S. growth in Q2 is expected to fall somewhere between -30% and -50% on an annualized basis (that wide range itself is a strange case, with usually finely-tuned measuring tools going out the window). The saving grace is the expected temporary nature of the extreme drop, with a recovery maybe not being the ‘V’ shape some hoped for, but perhaps a ‘U’. This would mean a mid-year troughing of activity, and gradual pickup in later 2020 and early 2021. This doesn’t mean there won’t be damage, with defaults and bankruptcies rising, despite the flood of government monetary and fiscal stimulus. However, the gradual reopening of regions and industries has generated some optimism that the worst is behind us. Nevertheless, full-year 2020 economic growth appears to be heading somewhere around the -5% range, which the Fed itself noted, with 2021-2022 expected to show stronger recovery trajectory. The timing and magnitude of recovery numbers remain in flux.
Inflation: One notable tendency of recessions is inflation falling off a cliff, due to a softening of aggregate demand. This has happened under Covid as well, with headline 12-month inflation rates declining from near-Fed target 2.0% down to 0.1% for headline CPI (affected by oil prices) and 1.2% for core, as of this morning. However, offsetting this weaker demand are supply chain disruptions, affecting food distribution and creating shortages in some consumer products, leading to higher prices in those areas. Some worry that the flood of stimulus not only in the U.S., but around the world, may act as a catalyst for higher monetary-based inflation. This is far longer debate, to be hashed out in years to come.
Employment: Prior to Covid, the reversal from decades-low sub-4% unemployment early in the year, to a Great Depression-like spike, would have never been believed. The nature of job loss is important, in that many of these are expected to be temporary layoffs as officials completely closed down certain portions of the economy preemptively, with hopes of a gradual reopen as soon as possible. This explains the massive jobless claims numbers, while other small businesses have been kept afloat with government assistance, as a ‘bridge’ to the other side back to normalcy. (There are also some measurement issues affecting how government statistics classify ‘furlough’ versus ‘layoff,’ etc.) The timeline of this return to normal remains fluid, controlled by the virus’ path, but re-opening is gradually widening nationally. This is good news from at least an economic front, as the longer a shutdown lasts, the more difficult it can be to sustain traction in business sustainability and worker skills. As it stands, it’s estimated that the unemployment rate may still be as high as 10% by the end of this year, and stay the mid- to higher-single digits in 2021.
The investment world has experienced a roller-coaster of its own, with the steepest/fastest decline in decades (stocks down near -35%), followed by one of the fastest recoveries (near +45%). Not that we need another one, but this serves as a reminder that financial markets look ahead to hopes and dreams for the future, but aren’t always an accurate mirror of the present. This is again the case, with analysts essentially ‘throwing away’ 2020, and looking to 2021-22 for a resumption of growth estimates. The future path remains very dependent on Covid, the retreat/persistence of which may drive economic growth, employment, company earnings, credit health, and additional government actions (the latter of which drive the critical interest rate inputs).