Citing continued risks to the U.S. economy from the COVID-19 pandemic, the Federal Reserve (Fed) left short-term interest rates unchanged at 0% to 0.25%. The Fed also reiterated its commitment to use its full range of tools to support the U.S. economic recovery.
At the conclusion of its September policy meeting, the Fed noted it would maintain its near-0% rate policy until labor market conditions reflect “maximum employment” and inflation rises. Most Fed officials expect short-term rates to remain at their current level through 2023.
We believe the Fed may offer more clarity regarding their forward guidance by year-end.
The Fed maintained a cautious tone overall, refraining from major policy changes or details ahead of the November election. Many Fed watchers hoped policymakers would provide the metrics they will use to end the near-0% rate policy. However, most Fed officials want more clarity about COVID-19’s trajectory and the economic outlook before providing specific details. We believe the Fed may offer more clarity regarding their forward guidance by year-end.
In addition to holding rates steady, policymakers maintained the prevailing pace of bond buying at $120 billion per month. The Fed launched the bond-buying plan in March to help restore normal market functioning in the wake of the pandemic-prompted sell-off. In its September policy meeting statement, the Fed reveals it’s also maintaining QE to support the economic recovery from the coronavirus crisis.
With the economic recovery now influencing the Fed’s bond buying, there are questions about when or how the Fed may change its QE strategy down the road. The Fed has been purchasing $80 billion in Treasuries and $40 billion in mortgage-backed securities each month since June. Currently, the Fed is purchasing a range of short-, intermediate- and long-maturity securities. Some observers question whether the central bank eventually will focus on longer-maturity securities to keep rates low across the yield curve. The Fed implemented this strategy during its previous bond-buying program.
Meanwhile, officials formalized their recent switch from explicit inflation targeting to an average inflation goal. The Fed originally announced the change at its annual economic symposium in late August. Under this new framework, the Fed will no longer proactively lift short-term interest rates to stave off rising inflation. Instead, the central bank will allow inflation to climb moderately higher than its long-standing 2% target to make up for periods of weak inflation. This strategy suggests interest rates will remain low for a longer period of time, even if employment rises.
Under this new framework, the Fed will no longer proactively lift short-term interest rates to stave off rising inflation. This strategy suggests interest rates will remain low for a longer period of time, even if employment rises.
Inflation has persistently remained below the Fed’s 2% target for the last several years. This occurred even as the labor market reached full employment, causing the Fed to abandon the notion that low unemployment will drive inflation higher. Officials said they would “aim to achieve inflation moderately above 2% for some time so that inflation averages 2% over time and longer-term inflation expectations remain well anchored at 2%.”
The Fed noted economic activity and employment have improved recently but remain well below their pre-pandemic levels. However, the gains were enough for the Fed to modestly boost its 2020 economic forecast. Policymakers now expect the nation’s gross domestic product (GDP) to contract only 3.7% this year. In June, the Fed projected the economy would shrink 6.5% for the year, due to the unprecedented nationwide shutdown of business activity in response to the COVID-19 pandemic. The Fed expects GDP to expand 4.0% in 2021, slower than its June projection of 5.0%.
Policymakers also expect the jobs market to fare better, as they lifted their projected fourth-quarter unemployment rate from 9.3% to 7.6%. The Fed expects the unemployment rate to dip to 5.5% in 2021 and 4.6% in 2022.
We generally agree with the trajectory of the Fed’s economic forecast. However, we are less certain about the pace of the recovery, given the uncertainties surrounding the virus, election outcome and the fiscal stimulus. Recent labor market and other economic gains are encouraging, but data have a long way to go to reach early-2020 levels.
We expect more specifics regarding Fed policy to emerge after the election. By then, the Fed will have additional economic data, political insight and information on vaccine progress.
Financial markets will likely focus on the Fed’s bond-buying strategy. In our view, by shifting its motivation from financial market stability to economic recovery, the Fed’s may rely on QE as a more permanent fixture of monetary policy. In fact, policymakers may implement some form of open-ended bond buying that persists beyond 2020. Although the Fed hasn’t provided details about its longer-term bond-buying plans, we expect the central bank to clarify its strategy as the economic picture sharpens.
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