Fed urged to back up new dovish policy with action

Investors look for guidance from US central bank as hopes of fiscal stimulus to prop up economy fade

The Federal Reserve is facing calls to translate its new more dovish monetary framework quickly into policies to support the US economy, amid waning expectations of additional fiscal stimulus to keep the recovery going.

The Federal Open Market Committee — the US central bank’s rate-setting body — is set to meet this week for the first time since last month’s approval of a long-term strategy shift. The Fed said it would allow periods of higher inflation as it strengthened its commitment to reach full employment.

The change, which ditched the Fed’s decades-old mantra of pre-emptive rate cuts to stymie spikes in consumer prices, has set the stage for years of rock-bottom interest rates in the US as the world’s largest economy faces a slow and uncertain rebound from the shock of the pandemic.

Although the Fed’s dovishness has never been in question throughout this year’s crisis, many investors and economists said the US central bank needs to apply the new philosophy speedily to its policy statement and guidance, possibly as early as this week, to show its commitment to the plan.

“The Fed announced its new strategic objectives two weeks ago, and now it is time to back them up with concrete actions,” Aneta Markowska and Thomas Simons, economists at Jefferies, said in a note on Friday. “Not doing so would undermine the credibility of the new framework. And, when it comes to central banking, credibility is everything,” they said.

Recommended

Gavyn Davies
The Fed risks higher inflation to boost jobs

The Fed’s economic projections for this year are expected to show an improvement compared with the 6.5 per cent contraction in output and year-end 9.3 per cent unemployment rate in the median forecast of officials in June, but the outlook remains extremely hazy.

Most economists and Fed policymakers hoped that the White House and Congress would have delivered at least $1tn in additional fiscal stimulus to the US economy by now. However, negotiations on a new relief package have stalled and hopes of a deal have dwindled, raising fears of a looming hit to consumption and a wave of business failures and job cuts. This week’s FOMC meeting will be the last before the US presidential election in early November, adding to the political uncertainty.

Meanwhile, the coronavirus crisis is far from resolved in the US, despite the decline in cases since the spike in infections over the summer, with many schools starting classes remotely and businesses operating well below capacity.

In its last policy statement in July, the Fed said it would not raise interest rates until it was “confident that the economy has weathered recent events” and was on track to reach its goals. But economists said it can now be more explicit and firm in light of the new policy framework.

“The stage is set very nicely for them to adopt outcome-based forward guidance which would be driven by the overshoot of the inflation target . . . that they will remain at the zero lower bound until they are confident that they will be able to run at 2 per cent for some time,” said Michelle Meyer, a senior economist at Bank of America.

“And in the press conference [Fed chair Jay] Powell will do his best to further explain why the Fed made the changes they made, why they think it’s appropriate to reinforce the inflation objective right now,” she added.

Concrete policy changes at this week’s Fed meeting are far from certain, however. Some Fed officials have in recent weeks argued that the central bank’s current language has been sufficient to satisfy markets of its determination to keep rates on hold for a very long time. They assert that it is not necessary for the central bank to bind itself to more specific targets that could limit its flexibility in the future.

But investors are clamouring to know how exactly the Fed’s new framework will work in practice, and warned that otherwise it may end up being dismissed as a purely theoretical exercise.

“Increasing your desire doesn’t increase your credibility,” said Gene Tannuzzo, deputy global head of fixed income at Columbia Threadneedle. “They need to demonstrate not just a willingness for inflation to go higher, but also what [they are] going to do differently to get there.”

They need to demonstrate not just a willingness for inflation to go higher, but also what [they are] going to do differently to get thereGene Tannuzzo, deputy global head of fixed income at Columbia Threadneedle

Former Fed chairs Janet Yellen and Ben Bernanke have also nudged Mr Powell to be more specific. At a joint event at the Brookings Institution this month, they both endorsed the US central bank’s big strategy shift but both said they would give it an “incomplete” grade because of the unanswered questions surrounding its implementation.

“I think they have come to an excellent conclusion. They ran a very good process. They still need to translate this into something more operational. They need some forward guidance about the path of rates and asset purchases,” Ms Yellen said.

Beyond the tools under consideration to achieve the average inflation goal, investors also want to know the parameters the Fed will use to determine when it is appropriate to eventually tighten monetary policy. 

“Let’s assume we get the unemployment rate dropping substantially to the extent where we start to see inflationary pressure. Over what period of time will the Fed be staying put? That is a point the market does not have too much clarity on,” said Diana Amoa, a fixed income portfolio manager at JPMorgan Asset Management. 

Fed officials appear to have distanced themselves from another tool — yield curve control — which involves the central bank setting targets for certain Treasury yields and then buying or selling as many securities as necessary to maintain those levels. In remarks delivered at the end of August, vice-chair Richard Clarida said the potential benefits from such a policy were only “modest” and noted the potential for “complications in terms of implementation and communications”.