What the Fed Did Wednesday and What It Means for 2021

For a Fed meeting that was so hotly anticipated, it kind of turned out to be a dud. There was no change in the quantitative easing program, very little change in forward guidance, and even the press release was hardly changed. This may seem like a head scratcher to readers. Why is the Fed talking such a big game but doing so little? Here are some thoughts on what happened Wednesday and what it means going forward. A little more conversation, a little less action The Fed didn't do anything at their December meeting. Some thought they might respond to the recent uptick in rates by altering the QE program in an attempt to push rates lower. However the Fed kept the QE program unchanged. The only major thing they actually did was a small tweak to forward guidance. Let's cover QE first. As I've been writing recently, I think the Fed has soured on QE as a stimulus tool. It is very effective as a liquidity tool, but once markets are properly functioning, QE has very little effect. Here's the chart I ran back in October. Source: Federal Reserve Bank of New York Not only does QE not really work, even if it did, it would be of limited value. Say they could get the 10-year 20 basis points lower by doubling their longer-term bond purchases. How much better off is the economy? It would be extremely marginal. Meanwhile, there are risks of the Fed buying too many Treasury bonds. It can gum up the repo markets by draining available collateral. It is extremely difficult to unwind if that ever becomes an issue. And the more they buy now, the less they can deliver a shock and awe effect of buying more should inflation slow. Treasury yields moved marginally higher right after the Fed's press release, with the 10-year moving about 2bps higher. The Fed did say they would buy government bonds at least at the current pace, so the door is open Forward guidance? Technically the Fed did supply some forward guidance, saying that the QE program will continue until substantial further progress has been made toward their employment and inflation goals. This is so vague as to be almost worthless. Since we already knew the Fed would not be tightening policy until inflation rises substantially, it is hardly surprising that bond buying will also continue for some time to come. I feel like this is one of those memes where someone says, I don't know who needs to hear this but... and then says something obvious. In fairness to Jerome Powell and team, the average inflation targeting strategy has built-in forward guidance. Anything else they tell us is really superfluous as long as they stick to the average targeting methodology. Powell called their message powerful during his presser, but the power is really in the AIT framework, and that had already been communicated. The Fed's communication challenge On one hand, the Fed has few tools they can realistically employ. I just said QE isn't very effective. Buying other kinds of bonds would be similarly weak sauce. How much lower are corporate or municipal bond yields going to go? They can't realistically move any bond yield enough to make a big difference in access to capital. Anything else they might try (like helicopter money) would be pretty radical, and hence not being actively considered. On the other hand, the Fed very much wants to sound like all options are on the table. This is a lesson Powell learned from the aftermath of the Great Recession. At that time then-Chair Ben Bernanke tried to carefully calibrate market expectations. If markets expected some Fed action that wasn't forthcoming, Bernanke would give some speech indicating why further action could cause inflation or asset bubbles or some such. Unfortunately, this was often interpreted as more hawkish than he intended, and as a result sowed confusion. Powell is trying to sound all dovish all the time. As an example, I think as rumors of a QE expansion were growing over the fall, Bernanke would have pushed back because he didn't want to disappoint the market. Powell isn't worried about that. He never wants to say anything that sounds hawkish and create even the slightest impression that the Fed might remove any accommodation anytime soon. Why does he sound so sour? If you look at the Summary of Economic Projections, FOMC members have upgraded their economic outlook in a major way. The GDP estimates for 2020, 2021 and 2022 were all upgraded. Same with unemployment. And yet there was no change in how the Fed described the economy in the press release: The ongoing public health crisis will continue to weigh on economic activity, employment, and inflation in the near term, and poses considerable risks to the economic outlook over the medium term. It is wild when you think about it. Between the prior Fed meeting and now, we not only found out that multiple companies had discovered vaccines, but these vaccines are already being utilized. And yet the Fed doesn't change one word of their economic outlook? This gets back to my point above. Powell doesn't want to sound hawkish in any way shape or form. He also wants to keep pressure on Congress to pass fiscal relief. What does this mean for 2021? While changes to QE (or any other Fed actions) can't be ruled out, I continue to expect very little Fed action in 2021. Rather they will let the power of very low interest rates to work their magic. As the economy improves next year, the Fed will remain on the sidelines, which is different than any other recovery in history. We will probably get unemployment below 5% sometime next year or maybe into 2022, and it is likely that the Fed is still at a 0% rates target when it happens. Don't sell short how powerful this will be. It will just require some patience.

What the Fed Did Wednesday and What It Means for 2021

Why is Powell talking such a big game but doing so little?

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