As expected, the Federal Open Market Committee (FOMC) did not announce a major shift in monetary policy following the July meeting. The Fed statement included only minimal changes to reflect the economic recovery seen in May and June, while during the press conference, Fed Chair Jerome Powell emphasized the importance of the path of the pandemic on the economic outlook, noting the concerning pace of virus spread and loss in economic momentum evident in the higher-frequency indicators of consumer spending and hiring in July.
Since the last FOMC meeting, there have been two main economic developments. First, the rise in new COVID-19 cases and hospitalizations in various regions of the U.S. has accompanied a loss of economic momentum, which started in July. And second, the likely size of an additional fiscal stimulus package has grown – we now expect Congress to pass another $1.5 trillion to $2 trillion in additional economic support. These two factors have offsetting implications for the near-term outlook for growth, supporting the Fed’s decision to be patient at the July meeting and await further clarity.
Powell also hinted that in September, the Fed could release the conclusions of its multiyear review of monetary policy strategy, at which point we expect the Fed also will announce stronger forward guidance on interest rates and asset purchases. The Fed’s objective is shifting from managing a major financial market crisis toward keeping monetary policy conditions easy, and we think Fed officials will reveal their commitment to keeping rates steady until they are certain that inflation will sustainably achieve the 2% PCE (personal consumption expenditures) inflation target. To be sure, they are likely already operating under this notion, but the September announcements will likely make it clear to markets through the strategy review conclusions and also the addition of 2023 forecasts to the summary of economic projections (SEP), which could show still-low rates and forecasts for above-target inflation. This policy strategy draws on studies and conversations with the public about the economic benefits – including the labor market benefits to lower-income wage earners – of running the economy above potential.
Given the recent loss of economic momentum, it’s also possible that the Fed adjusts its purchases of U.S. Treasuries and agency mortgage-backed securities (MBS) to provide more accommodation. In any case, we believe asset purchases will be maintained at least through 2021, and rates will be on hold through the majority of 2023, if not longer. Still, with long-term rates near historically low levels, and the market fully pricing in a rate hike in mid-2024, we don’t expect a major reaction in the government bond market to the Fed’s upcoming announcements.
Clear policy guidance could help keep financial conditions accommodative
Stronger forward guidance could take several different forms, from date-based guidance to outcome-based guidance focusing on the Fed’s unemployment and inflation goals. With the benefit of the lessons learned after the global financial crisis, we think the Fed prefers forward guidance linked to inflationary outcomes. Still, we think it will stop short of implementing a formal average inflation targeting strategy.
Currently, the Fed operates under what it calls a flexible inflation targeting approach. It relies on its forecasts of inflation relative to the 2% target along with measures of labor market utilization and economic growth to help it decide how and when to raise or lower the fed funds rate, aiming to achieve 2% inflation in the future irrespective of past deviations. In other words, it lets bygones be bygones.
Under an average inflation targeting strategy, the Fed would no longer let bygones be bygones, and instead aim to offset historical deviations of inflation to achieve a 2% average over time. The most extreme variety of this type of “make-up” strategy is a price-level target: The Fed would aim to achieve a price level over time, meaning that large undershoots for long periods of time would be offset by large overshoots for equally as long and vice versa.
This strategy is problematic for Fed officials for a few reasons. First, many worry that long periods of above-target inflation could erode the public’s trust in the central bank’s price stability mandate. Second, unexpected bouts of higher inflation due to temporary factors, including oil price spikes or droughts, would prescribe unduly tight monetary policy (and a higher unemployment rate!) to bring the price level back down again. To mitigate some of these practical issues, New York Fed President John Williams has proposed having a shorter “look-back” period by seeking to achieve 2% average inflation over a short averaging window. However, this strategy also comes with its own set of problems, including picking the optimal inflation averaging window, ex ante, given uncertainty around the outlook.
Looking to September, we think the Fed will announce something closer to the “opportunistic reflation” strategy that was coined by Fed Governor Lael Brainard and others, whereby the Fed tolerates and even aims for some temporary overshooting of its inflation target as we emerge from this recession, but doesn’t go as far as to set a formal rule. In practice, we think the Fed could achieve this by updating its forward guidance to explicitly commit to leave rates at zero until inflation sustainably returns to 2%, which implies a tolerance and even willingness to allow inflation to overshoot.
Duration of U.S. Treasury purchases on the Fed balance sheet
Given the recent loss of economic momentum evident in high frequency indicators of population mobility and small business revenues, along with employment, it’s possible the Fed will also provide further accommodation through changes to its current U.S. Treasury purchase program, specifically via extending the weighted average duration (WAD) of Treasury purchases. Currently the Fed is purchasing roughly $80 billion in Treasuries per month, with a WAD between 5.5 and 6 years. This WAD is well under previous programs, including the so-called open-ended quantitative easing (QE) program that ran from mid-2012 to mid-2015 with a purchase WAD between 10 and 11 years. Aligning the current purchase distribution to that of past QE programs would roughly double the amount of easing that could be achieved without increasing the par amount of purchases, and we would view this as an explicit change to the stance of monetary policy.
Bond market reaction (or not)
Still, in light of the initial conditions of low rates and easy financial conditions, the actions we expect in September, while notable, may elicit only a limited reaction from bond markets. On a risk neutral basis, the rates market is already pricing the Fed to remain on hold through mid-2024 – around a year after we are forecasting the labor market to return to levels consistent with maximum employment. And while we estimate that doubling the WAD of Fed Treasury purchases could lower 10-year term premiums by another 20 to 30 basis points, all else equal, the increase in Treasury supply resulting from higher federal government deficits would largely offset Fed buying.
Still, that should not stop the Fed from implementing the policies. Although financial markets have normalized and activity appeared to bottom in April, it will take several years of above-trend real GDP growth to bring the labor market back to full employment and inflation sustainably back to 2%. By implementing stronger forward guidance and signaling bond buying will continue for some time, the Fed is effectively hedging against markets prematurely pricing policy normalization, which unnecessarily tightens financial conditions.
Though markets are largely pricing in the anticipated September announcement on interest rates, we still think the Fed will want to lock in easy financial conditions to support the U.S.’s recovery after this unprecedented economic shock.
Explore our latest thinking on interest rates and their investment implications.
Tiffany Wilding is a PIMCO economist focusing on North America and a regular contributor to the PIMCO Blog.