The Federal Reserve made no key policy changes in their July meeting, as expected, keeping the fed funds rate at the lower bound of 0.00-0.25%. Earlier this week, the pandemic-based emergency liquidity/lending programs were extended until at least the end of 2020, and dollar swap lines for longer.
The formal statement noted some pickup in economic activity, but noted continued concerns over the human and economic risks posed by Covid. They expect to maintain this target level until substantial repair has occurred. At the risk of stating the obvious, the Fed’s opinion is best summarized by the newly-added comment, ‘The path of the economy will depend significantly on the course of the virus.’
The official indicators remain little changed since the pandemic began:
Economic growth: Although the current recession officially started in February, the cliff from which the economy fell in March, when pandemic-based government-mandated lockdowns were set in motion, created an unprecedented situation. The path forward remains open-ended, coming down to the ‘shape’ of recovery. While a few industries are hoping for a ‘V’, others are on a far slower recovery path (a ‘U’ or checkmark), including restaurants and much of the travel industry, and have a difficult road ahead. The depth of the decline has been covered at length by many, with the prospects for an eventual vaccine remaining the likely key recovery driver. (Estimates on a timeline for an effective vaccine have improved to around year-end or early 2021, which is a few months ahead of schedule; but the FDA trial/approval process remains fluid, not to mention production and distribution.)
At the same time, the longer the downturn, the higher the potential for certain segments of the economy to stagnate for far longer. Unless there’s a miraculous turnaround in late 2020-early 2021 (and even then perhaps), it’s hard to see the Fed proceeding with anything but accommodative low rates and quantitative easing policies. Fiscal stimulus, practically to the level of Modern Monetary Theory (MMT) thought unthinkable not long ago, has been added to help bridge the gap of economic damage. No doubt, the speed of the dual policy response (compared to 2008) has been lauded. Election years are tenuous times for politicians to face a recession, and dual-party support for stimulus has been consistent (apart from details and magnitude).
Inflation: In keeping with the drawdown in economic activity, traditional inflation metrics have also fallen back. This isn’t unusual during a recession, due to demand erosion. However, the underlying dynamics for different goods are far more nuanced. In the current case, food and medical prices have risen, along with selected supply disruptions, while lower activity has pulled down prices for retail goods, like apparel and autos. Importantly, shelter prices have remained steady, as home prices and rents have not been as negatively affected as some may have expected (with help from low interest rates and government income assistance). Of course, extreme volatility in energy prices has played a key role as well. Year-over-year CPI increases of 0.6% and 1.2%, for headline and core, respectively, should keep the Fed stimulative until signs of inflation pickup are obvious. Even then, inflation may be allowed to ‘run hot’ for a time to help the economy catch up to prior trend.
Employment: Job conditions remain understandably challenging. Continuing jobless claims are still elevated at multi-decade highs, with some industries, particularly those the highest numbers of lower-wage service workers (restaurants, hospitality, travel, gaming) remaining generally on hold. As with economic growth generally, this situation remains fluid, with government fiscal aid and enhanced benefits slated to help in the interim. The Fed has no impetus to even consider tightening policy until such a lackluster labor market situation improves. A key risk is that these workers end up unemployed or underemployed for far longer than expected if bankruptcies ramp up, based on regional or job qualification mismatches.
Economists have noted the problem of the Fed not having a lot of remaining monetary policy tools remaining in their toolbox to help get the economy back on track. Short-term rates at the zero bound are limited in terms of their further effectiveness. (They could be moved into negative territory, but there appears to be little appetite for this in the U.S., due to undesirable effects on the financial industry, as well as dubious evidence that negative rates even work.) Long-term rates have been targeted through QE functions, as well as the discussed yield curve caps. No one expects miracles out of monetary policy at this point, but the point in keeping rates low is to remove any hurdles that could get in the way of eventual recovery. While the Fed denies that they’re out of policy ammunition, they have acknowledged the need for fiscal stimulus as a necessary cornerstone of government response. Congress has delivered, with $1 tril. in CARES Act support, and a likely similar amount under the in-progress HEALS Act.
Investment markets have experienced an extreme full cycle of emotions since March. Risk assets have rallied due to the sharp government response, and expectations of a finite end to the pandemic, although that exact end date remains fuzzy. Interestingly, the gap has also widened between the tech and communications ‘winners’ and challenged businesses in old industries, where dynamics for success remain unclear. Lack of clarity surrounds behavioral impacts of the pandemic, such as the public’s comfort in venturing out again (revenue prospects for consumer discretionary/services), willingness to work in close quarters (office real estate), among other issues.
Other questions continue to fester. Why do Wall Street and Main Street seem so disconnected? The simple response is that the former is based on the future, and the latter is tied to the recent past—a fluid medical environment leads to a natural mismatch. The wider this disconnect gets, the higher the possibility for more volatility. And, are ‘growth’ stocks (like tech) overpriced? Based on low interest rates and historically strong levels of free cash flow and other solid fundamentals, some have argued that they actually may not be. This also explains success of ‘growth’ over ‘value’, which seems to have intensified, despite the growing cheapness of value segments. Bonds, on the other hand, are generally dependent on current yields to gauge returns over the next 5-10 years. While bonds always offer some degree of diversification value, it is potentially less than in the past, unless one increases risk in varying degrees by delving into credit markets for more potential return. Investor interest has grown for foreign equities, due to signs of improvement (in Europe particularly), and commodities, with debate over long-term inflationary impacts of fiscal deficits and monetary balances. It may sound like a broken record, but diversification seems to be the best choice, yet again.