This week, the Federal Open Market Committee (FOMC) delivered its most comprehensive assessment of the US economic outlook since the COVID-19 outbreak, and it’s not a pretty picture. The Fed expects the economy to run below its capacity for several years, and we agree with that perspective.
While the FOMC’s plans to keep interest rates at zero for the next several years provide some comfort, we think it missed an opportunity to do more to support economic growth. Hopefully, they’ll correct this mistake in the coming months if the outlook doesn’t improve dramatically.
Fresh Forecasts: A Quick Bounce, Then a Sluggish Recovery
The Fed provided its economic forecasts through 2022 for the first time since the pandemic’s onset. While the central bank sees a near-term economic rebound, it also sees the economy settling back into a sluggish recovery, with output below its previous peak for several more quarters.
That squares with our view: the next couple months will probably look great, with pent-up demand roaring back as businesses reopen and fiscal stimulus underpins consumption. But once that initial spurt fades, the reality of a deeply distressed labor market will likely weigh on activity for a while. The Fed expects an above-normal unemployment rate and a below-target inflation rate for the next two-and-a-half years—at least. That’s a gloomy forecast, but it makes sense to us.
What More Could the Fed Have Done?
Given that outlook, the Fed repeated that it expects to keep interest rates at zero and continue buying US Treasuries and mortgage-backed securities “until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.”
Keeping policy rates at zero and purchasing securities to tamp down rates across the curve is appropriate. But given the weakness of the Fed’s forecasts, it’s hard to see why it didn’t try to do more. If we reach the end of 2022 with unemployment still elevated and inflation still below target, the Fed will not have fulfilled its mandate.
This leaves the question of what else the Fed could have done to bolster the economy. It has ruled out negative interest rates, but the central bank does have other tools at its disposal. Fed Chair Jerome Powell singled out two of them, enhanced forward guidance and yield-curve control, in his post-meeting press conference.
Forward guidance with an explicit link. With enhanced forward guidance, the FOMC would link its plans to keep rates low and to buy securities to a specific economic variable.
It did this in the Global Financial Crisis, saying it wouldn’t raise rates until the unemployment rate fell below a threshold. Ultimately, the Fed didn’t raise rates even when that happened—because inflation stayed low. Because of that experience, we think the Fed would use a different variable this time around, linking rate hikes to inflation rising and staying at or above target for a sustained period.
Capping rates with yield-curve control. Yield-curve control would involve a pledge from the FOMC to cap interest rates on Treasuries. If the committee does make this move eventually, we’d expect to see a commitment to keep two- or three-year Treasury yields in line with the fed funds rate.
The idea would be to make forward guidance even more powerful: if the FOMC is committed to buying as many securities as needed to keep interest rates down, it certainly couldn’t raise the policy rate. This approach would also reduce interest-rate volatility and impact securities with longer maturities than the targeted range.
The Fed Misses an Opportunity
Powell made it clear that the committee is discussing these policy measures and may use them in the coming months. This week—at least seemingly—it preferred to wait for more information in what is a very unpredictable environment. We think the FOMC should have rolled out these measures this week, and that waiting is a mistake.
However, there’s still time for the Fed to act.
The market isn’t pricing interest-rate hikes yet, so the costs of waiting seem manageable, even if we think a more aggressive approach was warranted. If developments over the next few weeks improve the long-term outlook, this week’s inaction won’t matter. But if conditions don’t improve, we hope the Fed will be more forceful the next time around.
- Eric Winograd
- Senior Economist—Fixed Income