3 Important Questions the Fed Answered Wednesday

On Wednesday, the Federal Reserve concluded their normal January meeting. We knew there was not going to be any express change in policy, but this was still a highly anticipated meeting with lots of important questions going into it. Has the increased chance of fiscal stimulus boosted the economic outlook? If so, does this increase the chance the Fed starts tapering QE purchases soon? And lastly, are stocks in a bubble and if so what should the Fed be doing about it? Here is what the Fed said on each of those questions with some of my thoughts. Economic Outlook Downgraded In the Fed's press release, the language describing the basic economic outlook sounds more dour than in December. Economic activity has moderated with weakness concentrated in the sectors most adversely affected by the pandemic. They go on to say that the path of the economy will depend significantly on the course of the virus which is similar language used in the last few meetings. This downgrade might surprise some readers. After all, there's been more progress on vaccinating the public, Covid cases are lower, and companies are generally sounding optimistic in recent earnings calls. Certainly the stock market seems plenty ebullient. There's two big reasons why the Fed has used this more negative language. The Fed usually writes these releases thinking primarily about the most recent economic data. Because of the surge in Covid during November and December, the most recent employment data is worse, and the Fed usually acknowledges such a thing. The second, and more important, reason is a communication strategy. Chair Jerome Powell has said a couple times something to the effect that they aren't thinking about thinking about tightening policy. That logic is extending to how they talk about the outlook too. They will continue to strike a cautious tone about the outlook until the pandemic has truly passed. Do They Even Need to Taper? As I mentioned in last week's piece, there's been some chatter from regional Fed Presidents about QE tapering later this year. Powell pushed back on that idea. He described the QE program's sizing as depending on the economic outcomes, but then only gave an example where they'd increase QE buying. Partially this is about the same communications strategy I mentioned above. Powell wants to seem full-on dovish so as to avoid the 2013 taper tantrum-type response. However, we knew they weren't close to changing their QE strategy. It was only in December that they strengthened the language in the presser on QE, saying that they would buy at least at the current amount until substantial further progress has been made toward their goals. There's absolutely no reason to entertain tightening, even far into the future, when there hasn't actually been any progress toward those goals. Perhaps more notably, if you look carefully you'll see that the Fed is going to naturally taper in 2021 without actually changing their buying. We've heard a lot about the swelling federal debt, but actual issuance in Treasury bonds is expected to be similar in 2021 as 2020. That's because in 2020, the Treasury raised much more cash than they needed to meet immediate spending needs. As of Monday, the Treasury was sitting on over $1.6 trillion in cash vs. only about $400 billion at this time in 2020. So despite all the new stimulus plans Congress is considering, it may be that total Treasury issuance doesn't change much from 2020. In 2020, net issuance of all bonds and notes (i.e., excluding T-Bills) was $1.7 trillion. For discussion purposes, let's say that rises to $2 trillion in 2021. In 2020, the Fed bought a total of $2 trillion in bonds and notes. In other words, almost 120% of net issuance. Currently the Fed is buying at a pace of $80 billion per month in Treasuries, and if that were to continue for all of 2021, it would total about $1 trillion in buys. Hence, the Fed is probably going to be buying something like 50% of the net issuance of Treasury bonds and notes in 2021, vs. about 120% in 2020. In a sense, this is a taper without announcing it. That might be the best of all worlds. It will be interesting to see how the minutes describe the debate around QE purchases. I suspect Powell warned the Regional Presidents to stay on message, but of course that probably won't get recorded in the official minutes. What About Asset Bubbles? No one can deny that speculative behavior has been on the rise for several months. The whole GameStop controversy this week is just the latest example. Powell was asked a number of questions about asset bubbles and financial stability risks during his press conference. His answers were consistent with what he's said in the past. In his mind, it isn't clear that arresting asset bubbles before they burst is helpful. Furthermore, raising rates definitely hurts employment and economic growth. He said something similar, but more forcefully, back in June: the concept that we would hold back because we think asset prices are too high... what would happen to those people? What would happen to the people that we're actually legally supposed to be serving? We're supposed to be pursuing maximum employment and stable prices, and that's what we're pursuing. I think that summarizes his point of view on market speculation and the Fed's role thereof. Powell also downplayed the Fed's role in stock market speculation, saying that the link between low rates and asset valuation isn't as tight as sometimes people claim. I agree in the sense that people speculating on IPOs or SPACs and the like wouldn't be doing anything different if fed funds were at 1% or 1.5% or some such. In other words, it isn't like all those people were buying 2-year munis before but now low rates have forced them into speculation. At the same time, let's not be naive. Bubbles are caused by overconfidence. There are many people, even some pros, who think the money printer go brrr will prevent markets from ever going down. The perception is that the Fed has the market's back, and that is part of what's driving the overconfidence. In reality, the Fed couldn't care less if SPACs crater or if Robinhood traders get run over. In reality, the Fed will support market functioning, but not prop up markets at all costs. But that's not the perception. I don't think there's anything the Fed should do about it now, but it is silly to claim that they have nothing to do with the overconfidence rife in markets right now.

3 Important Questions the Fed Answered Wednesday

Powell was asked a number of questions about asset bubbles and financial stability risks during his press conference.

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