As expected, the Federal Reserve held its policy rate range steady at the January meeting, and the statement changed only modestly from December. In his press conference, Fed Chair Jerome Powell said that the Federal Open Market Committee (FOMC) still expects the U.S. economy to expand at a moderate pace, and reiterated the FOMC’s prior guidance that rates will remain on hold. More importantly, in light of still below-target inflation, he also emphasized the asymmetric nature of the inflation target and alluded that the FOMC would tolerate a period of above-target inflation if it were to occur, to ensure that inflation expectations remain well anchored at (not below) the inflation target.
After Wednesday’s statement and press conference, our base case outlook for the policy rate aligns with the Fed’s view. However, given our forecast for U.S. growth to slow somewhat more in the first half of 2020, and inflation to remain below target, we continue to see a lower bar to cutting rates relative to hiking.
Perhaps the more interesting takeaway was Powell’s guidance on the balance sheet. He stated that the FOMC is targeting a level of financial system reserves no lower than $1.5 trillion to fulfill its commitment to operating monetary policy in an ample reserve regime. Taking a step back, since the period of notable money market stress in mid-September 2019, the Fed has been doing technical operations, including temporary lending through repo auctions and outright purchases of Treasury bills, in an effort to increase bank reserves, calm money markets, and ensure the effective fed funds rate (EFFR) remains within the target range. In our view, these programs have been effective at their stated goals. As such, it’s natural that the Fed would wind them down. We think the Fed will pare down its current operations, leaving the average level of reserves around $1.55 trillion to $1.60 trillion while not allowing them to dip below $1.5 trillion.
Is the Fed back in the QE business?
Since the Fed starting providing liquidity to markets by increasing the level of financial system reserves, observers have asked whether these actions are a form of quantitative easing (QE) – Powell received this question multiple times during the press conference. However, we find the debate over the “QE” label to be beside the point. The relevant issue is the effects of Fed purchase operations on broader credit and monetary conditions.
Unlike the Fed’s purchase operation in the wake of the 2008 financial crisis, which aimed to ease credit conditions through lower Treasury yields, the current operations are focused on reducing money market volatility, improving bond market liquidity, and easing bank balance sheet costs in order to transmit monetary policy most effectively. We don’t believe the current programs have had a major influence on market participants’ overall outlook for the economy beyond reducing some low-probability risks for banks.
As for the actual impact on markets, we do see some impact on the targeted bond markets. Since the Fed began adding reserves again, government bond option-adjusted spreads relative to overnight index swaps (OIS) – a measure of the costs of holding a bond on a bank’s balance sheet – have tightened, similar to the behavior of the investment grade (IG) credit default swap index (CDX) relative to its cash IG bond counterparts. This suggests that the Fed’s operations have eased bank balance sheet costs for high quality government and corporate debt.
However, further out the risk spectrum toward high yield credit and equities, the effects are less clear. Perceived “risk-free rates” are used to discount the future earnings streams embedded in equity prices, so to the extent that bank balance sheet easing reduces government bond yields, equity prices should be affected, but the effects are likely to be small. Meanwhile, equity risk premiums (ERP) – the premium over “risk-free assets” that investors require to buy equities - have declined quite a bit (on the order of 100 bps, according to our measure). But taking a closer look, the decline appears to have little to do with Fed balance sheet policy. Indeed, ERPs peaked on 3 September, one day before the Trump administration announced that trade negotiations with China would resume, and ERPs continued to decline as trade tensions eased and nascent signs of a stabilization in global industrial production emerged.
Paring down the programs should not be a big deal for markets
Our base case is that the Fed will continue its $60 billion per month pace of T-bill purchases through April or May before reducing them to the pace necessary to keep up with currency in circulation growth (approximately $10 billion per month). Meanwhile, we also expect the Fed to continue to taper the size of the repo operations through April, when tax-related seasonal volatility in the Treasury account dies down.
As the Fed winds down these programs, we don’t anticipate market volatility to emerge – at least not as a result of the Fed’s actions. We believe the Fed’s balance sheet will remain at a permanently larger level than where it was last September (although maybe not as large as December). Moreover, we would expect the Fed to continue to gradually and passively expand the asset side of the balance sheet to keep reserves stable despite currency in circulation growth. The Fed could also introduce a standing repo facility as a backstop for U.S. funding markets during quarter-end or year-end periods when bank balance sheets become more constrained and money market volatility tends to pick up.
Tiffany Wilding is a PIMCO economist focusing on the U.S. and is a regular contributor to the PIMCO Blog.