Fed’s Semi-Annual Report to the Congress: Full Speed Ahead

Today, Federal Reserve Chair Powell testified before the U.S. Senate Banking Committee on the Fed’s Semi-Annual Report on Monetary Policy to the Congress. Powell’s testimony emphasized that the Fed’s overriding objective is to pursue its mandate of maximum inclusive employment and inflation modestly above 2%, and that while the economy has partially recovered, the recovery in employment—particularly among disadvantaged groups—has lagged, and so the Fed will maintain its current policies of zero interest rates and significant purchases of Treasuries and MBS for some time.

As Powell stated:

“We expect that it will be appropriate to maintain the current accommodative target range of the federal funds rate until labor market conditions have reached levels consistent with the Committee's assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time. In addition, we will continue to increase our holdings of Treasury securities and agency mortgage-backed securities at least at their current pace until substantial further progress has been made toward our goals.”

Also, in reviewing the Fed’s new strategic framework, Powell emphasized that the Fed has raised the bar for pre-emptive tightening, noting, “we will not tighten monetary policy solely in response to a strong labor market.”

What stands out in Powell’s testimony is what it does not mention, more so than what is included. The Fed is silent on any risks involved in its monetary policy, and how it may respond if things change and do not follow the Fed’s script. This is striking insofar as Congress chartered the Fed. The Senate Banking Committee, along with the House Financial Services Committee, is charged with supervising the Fed. In the current environment—which Powell noted is full of uncertainties—the Fed’s semi-annual report and Chair Powell’s testimony should have mentioned that the Fed is following potential risks and balancing them with its mandated objectives.

Since their March-April 2020 collapses, real GDP and employment have bounced back far faster than the most optimistic forecasts among FOMC members, although the recovery in employment has clearly lagged the recovery in GDP. The Fed’s latest official forecast—its December 2020 Summary of Economic Projections (SEPs) of 4.2% growth in 2021—does not reflect the enactment of the $900 billion fiscal stimulus package in December, much less the new $1.9 trillion proposal of the Biden Administration, and real growth is very likely to far exceed the Fed’s forecasts (Strong U.S. growth, inflation and the Fed’s challenges, February 11, 2021).

While the Fed favors inflation rising above 2% as a makeup strategy following the sub-2% inflation in recent years, it also emphasizes the importance of keeping inflationary expectations anchored to 2%. In the last six months, actual annualized inflation has risen above 2%, even though wide portions of the services sector has been constrained, and a reopening of the economy is expected to involve strong economic activity, which is also expected to lift inflation pressures. Recently, market-based expectations of inflation have lifted slightly above 2%, and bond yields have increased, and there is a risk they rise further as the economy reopens and the economy strengthens. In the current environment, the Fed’s failure to provide any range of inflation that it views as appropriate is inconsistent with its goal of being transparent.

The important question is not whether sustained zero interest rates and mounting Fed purchases of Treasuries and MBS increase the risks of financial instability—almost certainly they do, unless the natural rate of interest is zero and the Fed’s bloated balance sheet results primarily in excess reserves in the banking system rather than stimulating the economy. The more appropriate question is whether the Fed acknowledges that there are potential risks and is balancing those potential risks with the economic benefits of maintaining its current monetary policies. The recent “froth” in financial markets—including the startling volatility in specific stocks supported by new trading platforms driven by social media, the proliferation of SPACs, and the overall level of stock valuations—are to some degree likely facilitated by the Fed’s zero interest rates and excess liquidity. In our view, it would be appropriate for the Fed to acknowledge that it is aware of these behaviors and is considering the risks they pose.

Congress—Members from both sides of the political aisle—should be asking the Fed how it may adjust monetary policy if inflation or inflationary expectations rise to uncomfortable levels (and what are the Fed’s “comfort ranges”), or some potential risks to financial stability were to unfold. At this juncture, with the distribution of vaccines accelerating, the services sectors of the economy seemingly poised to reopen, and more sizable fiscal stimulus very virtually certain to be enacted, such a discussion and Fed transparency would be welcome.

Mickey Levy, mickey.levy@berenberg-us.com

Member FINRA & SIPC
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