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29 July 2020

The Fed: Planning for a Long Period of Easing

By John L. Bellows, PhD

The Federal Reserve (Fed) changed very little in its official statement following today’s Federal Open Market Committee meeting. Aside from a few housekeeping updates, the only real change was the addition of the following sentence: “The path of the economy will depend significantly on the course of the virus.” This, of course, is an uncontroversial observation and its inclusion didn’t shed much light on the future path for policy. Although it may have felt like a long time to most market participants, it appears that nothing in the last six weeks has altered the Fed’s assessment of the economic landscape or the risks ahead.

The absence of changes should not be interpreted as a sign of inaction, however, as the Fed has quite a lot on its plate right now. Next up is the monetary policy review, which has been ongoing since early last year. Chair Powell said that the Fed expects to bring the review to a conclusion “in the near future.” And while Powell was rather guarded in terms of what exactly the conclusion would involve, his comments did provide some hints as to what is currently top of mind for the Fed. In particular, Powell consistently returned to the topic of stress in the labor market as the Fed’s primary focus. He talked at length about the toll of the pandemic on the labor market, and the real hardships caused by widespread layoffs. At one point Powell said that the Fed’s role is to “push as hard as we can on our employment mandate while keeping price stability.” Powell’s ordering of mandates in that statement is worth noting: focus on employment while keeping an eye on inflation.

The monetary policy review may well adopt an average inflation targeting (AIT) strategy, which is something we wrote about last year. If that happens, one should not conclude that the Fed is focused exclusively or even disproportionately on inflation. To the contrary, Powell’s focus seems to be on the labor market. In that context, it’s important to understand that AIT, which would explicitly welcome an overshoot of the 2% inflation target, serves as a tool to allow the Fed to do even more for the labor market. With an inflation overshoot codified as part of the Fed’s strategy, the Fed would be freer to do as Powell suggests—“push as hard as we can on our employment mandate”—as it would be less constrained by expectations of inflation moving up. That could, in turn, help to address other ongoing issues. For example, today Powell responded to a question about income inequality by saying “a tight labor market is probably the best thing the Fed can foster to go after that problem, which is as serious one.” (Powell seems to be taking it as a given that the Fed should “go after that problem,” which is notable in and of itself). As the consistent revisiting of the theme makes clear, the labor market is Powell’s focus today, it’s likely to be featured in the Fed’s framework review “in the near term,” and it will be front and center for the Fed for some time to come.

After completing the monetary policy review, the Fed will turn immediately to its policy options. Today Powell was similarly guarded in his response to questions about specific policies. Perhaps more will be revealed next month, either in the minutes of today’s meeting or in presentations at the annual Jackson Hole conference. In the meantime, a few things are clear. First, the Fed is planning for a significant easing program. It doesn’t really have much of a choice, given the large distance to its mandates. The Fed’s own forecasts are that the unemployment rate is likely to be above 5% for the foreseeable future. And with regard to inflation, today Powell said “I think fundamentally this is a disinflationary shock.” In that economic context the Fed is appropriately planning on “decisive accommodation,” to use Governor Lael Brainard’s phrase.

Second, the Fed is considering a wide range of tools, likely focused on forward guidance and asset purchases. Forward guidance is now standard fare for central banks at the zero lower bound, and Powell hinted strongly that the Fed would adopt some form of guidance relatively soon. The comments on asset purchases were more noteworthy. For the second meeting in a row Powell said that asset purchases are now supporting financial conditions, and suggested they are a tool that will continue to be deployed as long as further accommodation is warranted. (Our own view is that neither negative rates nor yield-curve control is likely to be used this year, although Powell made no comment on either one today).

Finally, whatever the Fed ends up doing it will likely do so for quite a long time. Powell referred to the “long tail” of economic dislocation, and went out of his way to be clear that “Everyone should know that we're going to be there for all of that.” The Fed is planning for a prolonged period of accommodation and it will make sure that its policies can be sustained as long as needed. This, then, suggests the main takeaway from today’s meeting. Rather than trying to generate a catchy headline or short-term surprise, the Fed is preparing for an easing program that will likely characterize much of the next few years.