Fed underlines maintenance of zero rates and enhances forward guidance for asset purchases

*The Fed left monetary policy unchanged at its December 15-16 FOMC meeting and linked its forward guidance on its large-scale asset purchases (LSAPs) to substantial further progress on its maximum employment and price stability goals. For the foreseeable future, it will continue its LSAPs at least at the current pace – $80 billion per month in Treasury securities and $40 billion per month in mortgage-backed securities (MBS). The Fed continued to project that leaving the Fed funds rate at 0-0.25% through year-end 2023 would be appropriate (Figures 1 and 2).

*In the Official Policy Statement and Chair Powell’s press conference, the Fed reiterated its commitment to using its full range of tools to support the U.S. economy during this difficult time.

*FOMC members lifted their real GDP forecasts for 2020, reflecting the stronger-than-expected rebound through Q3 (Figure 1). Inflation forecasts were not much changed, with headline and core PCE inflation still expected to reach, but not exceed, 2.0% at the end of 2023. They lowered their unemployment rate forecasts in light of the sharp decline in the unemployment rate through November.

*No Fed members dissented at this FOMC meeting.

The Fed enhanced its forward guidance by linking its asset purchases to progress on its dual mandate goals of maximum employment and price stability:

“In addition, the Federal Reserve will continue to increase its holdings of Treasury securities by at least $80 billion per month and of agency mortgage-backed securities by at least $40 billion per month until substantial further progress has been made toward the Committee's maximum employment and price stability goals.”

Although the Fed’s LSAPs have resulted in a massive $2.7 trillion increase in its balance sheet since mid-March and it continues to purchase $120 billion in securities per month, the Fed stands ready to adjust these purchases if more accommodation is needed. Possible adjustments the Fed have discussed include: 1) increasing the size of purchases from the current pace; 2) purchasing longer-maturity Treasury securities; 3) conducting purchases at the current pace and composition, but over a longer time horizon; and 4) purchasing longer-maturity Treasury securities while reducing the pace of purchases. We believe option #2 is the most likely adjustment if there is an undesired spike in bond yields and the Fed feels that additional accommodation is needed.

The Fed’s forecasts imply that it expects real GDP to regain its Q4 2019 level by the end of 2021. The median FOMC forecast for real GDP was revised up for 2020 (Q4/Q4) to a contraction of 2.4% from September’s forecast of a decline of 3.7%. The Fed forecasts that real GDP will grow by 4.2%, 3.2%, and 2.4%, in 2021, 2022, and 2023, respectively, all well-above its 1.8% estimate of sustainable longer-run growth. Moreover, most Fed members no longer see significant downside risks to their forecasts. Ten (out of 17) Fed members assessed the risks to their GDP growth projections as broadly balanced, up significantly from four in September, and only six Fed members viewed risks as weighted to the downside, down from 12 in September. We expect economic activity to decelerate through early Q1, then to reaccelerate once the pandemic ebbs. At that point, we believe the probability of stronger growth far outweighs downside risks.

Fed members lowered their unemployment rate forecasts in light of its surprisingly sharp decline to 6.7% in November. This decline reflects a combination of the solid rebound in employment and decline in unemployment, and declines in labor force participation. The median Fed member now forecasts for the unemployment rate at year-end 2020, 2021, 2022, and 2023 to be 6.7%, 5.0%, 4.2%, and 3.7%, respectively, down significantly from 7.6%, 5.5%, 4.6%, and 4.0% in its September projections. The FOMC members expect the unemployment rate to return to its pre-pandemic level by year-end 2023. When the economy and particularly the service sectors begin to normalize in 2021, we expect that the demand for labor will increase, but also as more people will re-enter the labor market, the decline in the measured unemployment rate will moderate (US labor market: big gains, big shortfalls, December 9, 2020).

Fed members project that headline and core PCE inflation will rise to, but not above, 2% by the end of 2023, despite its new flexible form of average inflation targeting which suggests it favors inflation above 2% for years to come. The median FOMC forecast for headline PCE inflation in 2020 was unchanged at 1.2%, and was revised down slightly for core inflation to 1.4% from 1.5%. The median forecasts for headline and core PCE inflation were revised up for 2021 and 2022 to 1.8% and 1.9%, respectively, from 1.7% and 1.8%, previously. Note that the confidence interval (based on historical forecast errors) for the Fed’s inflation forecasts between 2021 and 2023 is very wide, ranging from 1-3% (Figure 3). The Fed has yet to provide details on how far above 2% inflation it will be comfortable with and for how long. Presumably, the Fed’s reaction function at the time would be determined by inflation expectations and labor market conditions.

It seems somewhat ironic that now that the Fed’s new strategy is to favor inflation rising above 2%, the FOMC members forecast that inflation will rise to 2% and stop there. Typically, when policymakers set an objective, they forecast that it will be achieved. Does the FOMC’s inflation projection reflect the FOMC member viewpoints that because inflation has been shy of its target most of the time since it was established in 2012, inflationary expectations will remain moderate and constrain actual inflation, or does it reflect their perspective that they do not think the Fed’s current policies will work to stimulate the economy and generate higher inflation?

Only five (out of 17) Fed members projected that it would be appropriate to raise the Fed funds rate from its current 0%-0.25% by year-end 2023, with one member projecting a policy rate of 1.125%.

Figure 1:

Source: Federal Reserve Board

Figure 2:

Source: Federal Reserve Board

Figure 3: Median Fed projection for PCE inflation and confidence interval based on historical forecast errors

Source: Federal Reserve Board

Roiana Reid, roiana.reid@berenberg-us.com

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

Member FINRA & SIPC
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