The Federal Reserve doubled down on its zero-interest rate policy this week despite economic recovery in recent months. Per Fed officials’ expectations, they will look to keep interest rates at near zero through 2023. This forward guidance is completely consistent with recently announced changes to the Fed’s policy strategy to let inflation run above their 2% target. The Fed continues to lean into the downside risks of the coronavirus recession and use their monetary policy tools to support jobs growth, while indirectly boosting stock and risk asset prices. While their lower for longer interest rate policy is bullish, they were less committed to Quantitative Easing over the long term, and would prefer for Congress to step in with additional fiscal stimulus.
The Federal Reserve’s Federal Open Market Committee (FOMC) wrapped two days of a regularly scheduled session on Wednesday. In conclusion, the FOMC kept interest rates unchanged at near zero and signaled that the zero-interest rate policy may very well remain in place through 2023. The Fed “dot plot”, which depicts officials’ expectations for future interest rate levels, showed thirteen officials expect no changes through 2023, two officials expect an increase of 0.25%, one official expects an increase of 0.50%, and one official expects an increase of 1%.
The dovish stance on rates was foreshadowed by Federal Reserve Chairman Jerome Powell last month at their annual symposium. As we covered at the end of August (8/29 Weekly Strategic Insight), the Federal Reserve is shifting a long-held policy stance from containing inflation at a 2% target rate to promoting inflation that may run in excess of its target. In essence, the Fed will not preemptively raise its federal funds rate to prevent inflation from moving above 2%. They will allow the economy to run a little hot and inflation to rise above 2%, which follows the past decade of the economy running slightly cold and inflation not reaching or sustaining its 2% target. This policy shift creates an average inflation target of 2% rather than a target inflation ceiling of 2%.
Is the FOMC getting a little ahead of itself based on the recent history of low inflation rates? One economist compared it to booking a concert at Carnegie Hall before you learn how to play Chopsticks.
Maybe. But, they are going to give it a shot. The average inflation target strategy shifts the Fed’s focus to employment, supporting jobs, and wage growth rather than inflation control. This is a clear disavowing of the Phillips Curve – the concept that inflation tends to rise when the unemployment rate falls and vice versa. When the unemployment rate fell to a 50 year low of 3.5% in 2019 and early 2020 without a corresponding increase in inflation, the writing was on the wall. The cause has been difficult for economists to define, although the theories point to lagging wage growth led by globalization, the “Amazon” effect of e-commerce over brick and mortar, the rise of service sector jobs, and post-Great Recession conservative management.
In his remarks, Fed Chair Powell talked broadly about employment and the importance of the Fed doing all it can to support job growth. The concluding message was that a strong labor market is imperative for improving the lives of the American people and the overall economy. With that message and years of overestimating inflation based on the “natural rate” of unemployment, the Fed has ditched its old framework and will not preemptively raise interest rates just because the unemployment rate falls below a set level.
It is a higher bar to raise rates going forward. The primary implication is that the Fed is committing to an extended period of very low and negative real interest rates, even as economic activity accelerates. And, the Fed has underestimated the economic recovery thus far. As you will note in the chart below, the Fed’s economic projections increased across the board since their June meeting. GDP expectations for 2020 increased from -6.5% to -3.7%, and unemployment rate expectations for 2020 decreased from 9.3% to 7.6%.
The new policy stance is bullish in the traditional “don’t fight the Fed” mentality. With short term interest rates anchored for at least three years or potentially until inflation consistently runs over 2%, the Fed is boosting risk assets, and therefore, supporting higher stock valuations.
However, there was one area of policy that was a bit lacking and may have been the cause of a weak stock market reaction through the end of this week-end – asset purchases, aka Quantitative Easing. The Fed will continue buying US Treasury securities and mortgage-backed securities at their current pace ($80 billion per month of US Treasuries and $40 billion per month of mortgage-backed securities), but they did not commit to forward guidance or adjust the scope or scale of the program. Dr. Tim Duy, who writes Fed Watch, worries that they are not nearly as committed to asset purchases as they are to zero-interest rate policy. The Fed could easily wind down asset purchases if there are upside surprises to the economy.
It should also be noted that Fed Chair Powell has made delicate but resolute pleas for additional fiscal stimulus. He expects Congress will need to do more to compensate for income losses sustained by unemployed workers as well as revenue holes facing businesses and city and state governments because of the coronavirus pandemic.
Fed officials are eager for a fiscal boost for two reasons. First, with only monetary stimulus currently flowing, it exposes the limits of their tools. Second, the unique nature of the coronavirus pandemic’s shutdowns and constraints resulted in a big shock to the labor market that makes direct aid necessary.
Have a great Sunday!
Timothy W. Ellis, Jr., CPA/PFS, CFP®
Senior Investment Strategist, Wealth Strategist