Looking Beyond Market Stabilization To The Future Path Of Monetary Policy
Summary
- Over the coming months, we think the Fed's focus will shift from one of crisis management to one of keeping financial conditions easy.
- The Fed isn't expecting normal anytime soon, and was comfortable enough with the market's progress to begin dialing back its pace of purchases in early April.
- Instead of posting daily purchase schedules a few days or weeks at a time, which helped the Fed maintain flexibility and react to real-time liquidity conditions, the Fed is likely to announce an open-ended program, tapering the pace of purchases until it reaches a steady state monthly net pace of $100 billion per month for Treasuries and $25 billion per month for MBS.
- Over the next several quarters, monetary conditions will likely be set not only by Fed balance sheet policies, but also by the expected path of interest rates.
Coming into the April meeting of the Federal Open Market Committee (FOMC), the policy rate was already at the effective lower bound, and the Federal Reserve had already introduced a range of lending facilities spanning asset markets, all in an effort to mitigate the economic damage of COVID-19. As a result, the market expected little in the way of "new" programs to ease credit conditions.
Still, over the coming months, we think the Fed's focus will shift from one of crisis management to one of keeping financial conditions easy. Indeed, Fed Chair Jerome Powell hinted at this during the press conference Wednesday, saying that while the Fed's asset purchases support market functioning, they also "foster more accommodative financial conditions." As its objective shifts - and as early as June - we think the Fed will provide additional, more tangible, guidance on the path of large-scale asset purchases, and on interest rates.
Since mid-March, the Fed's balance sheet has swelled with an unprecedented pace of purchases of U.S. Treasuries and agency mortgage-backed securities (MBS). However, as markets pulled away from the brink of collapse, the Fed started to dial back the weekly pace of purchases in early April. Over the next few weeks, we think the Fed will likely continue to taper toward a "steady state" level, which it will then maintain at least through the fourth quarter of this year, by our estimates.
Eventually, as more information is gained on the depth of the recession and the extent of the recovery after the economy reopens, the Fed will also likely strengthen its forward guidance for the path of interest rates. The economic rebound is likely to be slow even as the economy reopens, and it will likely be some time before the U.S. economy reaches full employment and 2% core PCE inflation (the Fed's inflation target, measured by personal consumption expenditures). And by linking guidance to inflationary outcomes, targeting an inflation overshoot, and even perhaps announcing a formal yield curve target two to three years out, the Fed could help the economy continue to benefit, as appropriate, from easy monetary conditions.
Background: Fed balance sheet rationale and impact
After a sudden increase in market volatility and risk aversion in mid-March contributed to extreme price dislocations in Treasury and MBS markets, the Fed began purchasing these securities with the goal of restoring smooth functioning of markets central to the flow of credit to households and businesses. By stabilizing the low-risk "core" of the asset market, the Fed hoped to foster efficient and effective transmission of its monetary policy across all markets.
In the past few weeks, market liquidity has improved from the massive disruption in March, but has not returned to normal. Still, the Fed isn't expecting normal anytime soon, and was comfortable enough with the market's progress to begin dialing back its pace of purchases in early April. "Supporting smooth market functioning does not mean restoring every aspect of market functioning to its level before the coronavirus crisis," said Lorie Logan, manager of the Fed's System Open Market Account (SOMA), in a 14 April speech. She added, "Nor does supporting smooth market functioning mean eliminating all volatility."
Future path for Fed purchases
The Fed has decreased daily Treasury purchases from $75 billion to $10 billion per day, according to the New York Fed. But soon, in light of severe challenges to the U.S. economy (discussed in a recent blog post), we expect the Fed's objective to shift from restoring market liquidity to setting the appropriate level of monetary conditions. Indeed, by our estimates, broader financial conditions are back to levels witnessed in February, but because the economy has suffered an immense shock, we would argue that financial conditions should be easier.
Instead of posting daily purchase schedules a few days or weeks at a time, which helped the Fed maintain flexibility and react to real-time liquidity conditions, the Fed is likely to announce an open-ended program, tapering the pace of purchases until it reaches a steady state monthly net pace of $100 billion per month for Treasuries and $25 billion per month for MBS. We expect the Fed to commit to maintaining this pace until it is confident in the U.S. recovery and that it can sustainably meet its 2% inflation goal - meaning at least through the fourth quarter of 2020.
It's not a coincidence that our expectations for the Fed's total purchases in 2020 of $3.2 trillion are similar to our expectations for additional Treasury Department funding needs (over the baseline) due to pandemic-related relief and stimulus packages, both current and future. Indeed, we expect the Fed will strive to keep financial conditions easy by offsetting much of the additional Treasury supply. With the combination of virus-related stimulus measures (which are estimated to cost $2.3 trillion this year), automatic stabilizers, and our expectation that Congress is likely do more, we estimate additional Treasury funding needs reaching $3.2 trillion, on top of the $1 trillion deficit that we expected before the crisis. Adding it all up, this leaves our deficit forecast at over $4 trillion. Additional supply to the private sector could be close to $1 trillion, and Fed purchases of Treasuries and MBS fill much of the gap.
Outlook for the Fed balance sheet
As a result of the central bank's unprecedented actions, we project the Fed's balance sheet will reach a peak level around $8.5 trillion, versus a $4.2 trillion pre-pandemic level, with the risks tilted toward more. In addition to asset purchases, the Fed has announced various other lending and liquidity facilities with $2.5 trillion in total lending capacity. And while fees and disclosure requirements mean uptake in some of these facilities will likely be considerably less than capacity - similar to the experience of the Troubled Asset Relief Program (TARP) after the 2008 financial crisis - they're designed to backstop markets and could grow larger if market conditions again deteriorate.
The outlook for monetary policy is more than just the balance sheet
Over the next several quarters, monetary conditions will likely be set not only by Fed balance sheet policies, but also by the expected path of interest rates. Eventually, we think the Fed will want to strengthen its forward guidance on interest rates to help ensure that markets price in a path that is in line with its own expectations.
In order to support inflation expectations, the Fed will likely, for a time, tolerate or even target inflation above its 2% longer-term objective. And according to our inflation forecasts, this will likely leave interest rates at the zero lower bound well into 2022. By linking guidance to inflationary outcomes, and perhaps even announcing a formal yield curve target two to three years out, the Fed can help ensure the economy benefits from continued easy monetary conditions.
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