The Federal Reserve Open Market Committee took no action at their mid-September policy meeting, as expected, leaving the fed funds rate at the zero bound of 0.00-0.25%.
Lately, the action seems to be happening between meetings. The Fed announced a new inflation targeting policy that will utilize an ‘averaging’ method based on recent inflation trends as opposed to the simpler meeting-by-meeting assessment. This will now allow for some drift in permitted inflation above target that would help ‘make up’ for periods of weakness during the pandemic. Presumably, inflation would end up being somewhat symmetrical over time around the 2.0% target, but the main concern is low current levels. The low rate regime also pressure the dollar lower, which has some economic benefits and tends to ease policy further if successful. The key question from economists is whether it will work to stoke inflation as intended.
Today’s formal statement changed quite dramatically in language, and materials noted the changes regarding its new inflation stance, showing interest rate forecasts on hold through 2023. The 2020 economic decline of -6.5% previously noted, was now raised to only -3%. There were two dissents in the meeting, about language and long-term intentions rather than current actions—seeking more flexibility about future policy decisions as inflation and growth conditions evolve, as opposed to appearing ‘boxed in’ with the newer policy of letting inflation run higher than target. Overall, the statement was seen as dovish.
As for the primary mandates:
Economic growth: This year has been anything but normal, with a 1.5-3.0% trend level of annualized growth in recent years being replaced by an over -30% drop in Q2 (the worst since the Great Depression), followed by expectations for a 30-35% recovery in Q3. Combined, this will likely result in a mid-single digit decline for 2020, but perhaps offset by above-average growth in 2021. The path to normalcy will be cloudy for some time, with the byproducts of inflation and employment recovery being more important to the Fed than the noisier quarterly reports.
Inflation: Per the August CPI release, headline and core inflation came in at 1.3% and 1.7%, respectively. As mentioned, inflation targeting is the new official policy, which may seem subtle, but there are other potential byproducts with this tolerance for higher levels. If the Fed allows inflation to ‘run hot’ for a time, say to 2.5%, this may begin to also adjust future consumer and market inflation expectations higher. This plays a role when translating to estimates for market returns as well. For example, nominal bond yields contain both an assumed inflation component, and a real interest rate component. If assumed inflation is allowed to rise by 0.5%, while real rates are unchanged, equilibrium nominal interest rates should also eventually rise by 0.5%. This ‘tightening’ could have the opposite effect of what the Fed is intending. The real rate component could also rise if uncertainty over future inflation policy is in question. So, there are potentially meaningful side effects of policies that could be cumulative over time.
Employment: On a broad level, this has improved, when measured by some recovery in nonfarm payrolls and the unemployment rate (down to 8.4%)—although levels remain well below those of the early 2020 pre-Covid period. Struggles in measuring ‘temporary’ versus ‘permanent’ job loss accurately continues as conditions for service businesses in retail, food/beverage, and tourism, among others, remain in flux. While activity has certainly picked up in these areas, it remains far below (up to -80%, in some cases) pre-pandemic activity. A key Fed policy goal is helping repair markets, which could still take months or years, depending on the survival rates of smaller firms.
Investment markets have ‘melted up’ significantly since the trough of late March, during a summer of little volatility until more recently. Although 2020 is anything but traditional, autumn has historically been a period of more extreme equity market movements, especially with the added uncertainty of a Presidential election in less than two months. The Fed has essentially promised to keep policy accommodative for several years, which results in higher modeled fair values for all types of risk assets—from equity prices to corporate bond credit spreads. Any additional fiscal stimulus from Congress and, of course, vaccine progress, could further enhance the outlook for many risk assets.