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Fed Watch And A Glimpse Of The Future

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EDITOR NOTE: This piece digs into the “message behind the message” as coming straight from the Federal Reserve, specifically Loretta Mester, President of the Cleveland Fed. Markets have generally been optimistic with Fed support as the tailwind to justify corporate debt and investment. But a line buried within Mester’s speech says it all:  “Monetary and fiscal policy are not substitutes; they are complements.” Complement to what? Clearly, the Fed knows its limitations--it can’t go it alone, and it risks losing control of the very thing it’s currently trying to generate: inflation. In short, it’s a game of timing and agility. While the Fed is confident in its capacity to remain “accommodative,” it also knows that the pandemic--whether it continues to spread, or whether the vaccine rollout proves less successful than we expect--is more than capable of delivering economic shocks, quite possibly unprecedented. It’s not an environment for any of us to navigate without an anchor to safety.

Fed chatter picked up with the ASSA meetings underway. So far, the primary story is as expected – concern for the near-term and optimism for the medium-term with an projection that policy will remain accommodative for the foreseeable future. While that is not exactly earth-shattering news, there are some interesting elements that help illuminate the way the Fed is thinking about its role in supporting the recovery. In particular, it is evident that accommodative policy does not mean unchanged policy especially with regards to the asset purchase program.

First up is a speech by Cleveland Federal Reserve President Loretta Mester. Her outlook is fairly straightforward:

…I expect the recovery to continue, but to be uneven over the year. In the near term, the current surge in virus cases is likely to weigh on activity this winter as the surge is managed through social distancing and targeted shutdowns, albeit ones that are less severe than those last spring. As the surge is brought under control and more people become vaccinated, I expect economic activity to pick up. Assuming that most people are vaccinated by the third quarter of the year, I expect to see a strong pickup in economic activity in the second half of this year as people and businesses feel it is safe to re-engage in a broad range of activities.

Mester’s timeline:

I expect this post-vaccination phase of the recovery to continue over the next few years, with growth above trend, declines in the unemployment rate, and gradually rising inflation. Given the severity of the pandemic shock, it will take time to move to a more broad-based sustainable recovery.

That’s basically the three-year benchmark for recovery that we can find in the Summary of Economic Projections. What does this mean for policy? First, the Fed can’t go it alone:

My modal outlook, which I just described, depends on appropriate policy. In my view, both fiscal policy and monetary policy will continue to be needed to limit lasting damage to the economy from the pandemic and support the achievement of a broader, sustainable recovery. Monetary and fiscal policy are not substitutes; they are complements and we saw them working together very effectively earlier last year when the pandemic hit.

This pushes back on the idea that the Fed can simply ease monetary policy if fiscal policy falls short of the mark. It helps explain why the Fed wasn’t particularly eager to ease policy this fall even when it looked like fiscal support might not happen. Financial conditions are already very accommodative; there is a limit the Fed thinks is possible in the current environment. Mester approves current policy:

The current stance of policy is well calibrated to my outlook. A slowdown in the economy in the first part of the year along the lines I am expecting would not require a change in monetary policy so long as the medium-run outlook remains intact.

This is the Fed looking through anticipated near-term weakness. Fiscal has already covered that problem and the Fed instead is setting policy for the medium-term. Regarding the medium-term, Mester also acknowledges that the expected improvement won’t cause her to rethink the policy direction:

Nor would the strengthening in growth I expect to see later this year necessitate a change in our policy stance because I expect that the economy will still be far from our employment and inflation goals.

But that’s the expected improvement. Things can change:

Of course, if the economy evolves materially differently than expected or if risks, including those to financial stability, emerge that could impede attainment of our monetary policy goals, we would be prepared to respond appropriately.

If the economy looks likely to recover in materially less than three years, then policy accommodation would be pulled back sooner than anticipated. Notice too that Mester also includes the financial stability caveat; I don’t think this is an issue yet, but the Fed is always a little fearful that the financial cycle will get ahead of any inflation cycle.

Mester’s final point is particularly interesting:

While achieving our goals will take some time, I do not view this as a failure of monetary policy or a lack of commitment on the part of policymakers to achieve our goals. The economy’s intrinsic dynamics suggest that inflation is not going to move up quickly above 2 percent. And the severity of the pandemic shock and its disparate impact across households, communities, and sectors suggest that it will take time to return to strong labor market conditions like those we experienced prior to the pandemic.

There is a persistent tension between the Fed’s forecasts and the policy choices. The Fed insists its tools are still powerful and yet they don’t use those tools to try to accelerate the recovery. Mester’s point is that the “economy’s intrinsic dynamics” force the recovery along a certain timeline that is beyond the control of the Fed. The Fed is finally realizing they need to more clearly explain why it doesn’t think the forecasts are inconsistent with the policy path.

Next up is a speech by Chicago Federal Reserve President Charles Evans. Much of the speech is devoted to an explanation of the new policy framework. As is well-known now, the Fed’s new policy is “flexible average inflation targeting” in the sense that it hasn’t set a firm timeframe on when it will have reached the inflation objective. Still, the implications for policy are obvious:

Now, we are not going to follow a strict numerical formula for moving policy. Still, these examples illustrate an inevitable bottom line: It likely will take years to get average inflation up to 2 percent, which means monetary policy will be accommodative for a long time. This translates into low-for-long policy rates, and indicates that the Fed likely will be continuing our current asset purchase program for a while as well.

Like Mester, Evans thinks the Fed can’t just flip the switch on inflation. Consequently, policy will remain accommodative for a long time. I thought in interesting though that policy rate will be low for a long time while the current asset purchase program will remain for just “a while.” That suggests what I think we all recognize will happen – the Fed will taper the pace of asset purchases before raising interest rates. Of course, like Mester he notes that the economy will guide actual policy outcomes. He added to reporters:

“Our current way of doing the $120 billion of purchases every month is reasonable across a wide range of maturities; if we see that we need more accommodation we could adjust and move the current pace into a longer duration, or we could expand the pace of purchases, or, if we saw that things were going better we could change the duration as well,” Evans told reporters after participating in a panel at the annual meeting of the Allied Social Science Associations.

This seems to me important –the Fed is thinking that they may need to alter the asset purchase program this yearAnd while Evans reasonably opens up the possibility that this can either way toward more or less accommodation, we know that some Fed officials are already thinking of tapering asset purchases. We saw this last year with Dallas Federal Reserve President Robert Kaplan and now we have this from Atlanta Federal Reserve President Raphael Bostic via Reuters:

“I am hopeful that in fairly short order we can start to recalibrate,” the $120 billion in U.S. Treasury and mortgage-backed securities that the U.S. central bank is currently buying each month, Bostic said in an interview with Reuters.

Oddly, Bostic seems to go a step further:

“I am hopeful that moving on into this year that the signals for weakness start to dissipate and the conversation turns consistently and robustly to sort of steady and broad-based growth,” Bostic said. He added that he was hopeful also that progress will be enough to let the Fed bring its asset holdings back to a level “more in line” with what existed before the pandemic.

That’s more than just tapering, that’s suggesting balance sheet reduction I think. And I don’t know what “more in line” can really mean. The Fed’s balance sheet has increased by over $3 trillion. Bostic can’t reasonably be thinking that the Fed is going to reverse that anytime soon.  If this is what Bostic really means, it seems well outside the consensus view at the Fed.

Bottom Line: These early 2021 Fed speeches provide a glimpse of the policy issues ahead. Near-term policy is locked in with no changes, interest rates are locked down until inflation accelerates meaningfully (a period of years), and the real focus will be the timing and nature of changes to the asset purchase program. Those changes could occur this year. And well there will not be any rate increase this year, it is easy to see that a shift toward tapering would only occur if the projected lift-off from zero was pulled forward. I said Monday that we should expect some chatter about tapering; I didn’t expect it so soon.

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