The Full Story:
On Wednesday, the Federal Reserve released its FOMC statement on monetary policy, its summary of economic projections, and held its press conference for elaboration. Overall, with longer-term interest rates lunging higher, many wondered whether the Fed would signal changes in policy or guidance to intervene. They did not. They provided minimal changes to the statement, remaining committed to 0% interest rates and $120 billion a month in quantitative easing. Changes in the summary of economic projections acknowledged the quickening pace of economic growth but outlined no changes in the federal funds rate through 2023. Observers confused by the bullish outlook on the economy and the bearish view on interest rate policy must dig deep into the press conference transcript for answers. For those of you unwilling or uninterested in doing it yourselves, good news… we’ll do it for you!
So… When Will the Fed Tighten Policy?
The Fed has three main mechanisms for withdrawing monetary stimulus. First, they can change their guidance and signal that they expect to tighten policy in the near term. Second, they can reduce or discontinue their purchases of Treasuries and mortgages, otherwise known as quantitative easing. Lastly, they can raise interest rates. Chairman Powell committed to actioning these tightening tactics in sequence, implying a “no surprises” pathway for investors. We appreciate this. Periodically, the Fed intentionally or unintentionally surprises markets, which rarely turns out well for investors (see the “Bond Massacre” of 1994 and the “Taper Tantrum” of 2013). Clearly from his statements on Wednesday, he sees no need currently to change guidance, trim asset purchases, or raise rates. However, confoundingly, the Fed did upgrade its economic projections significantly. In December, the Fed expected that the US economy would grow 4.5% in 2021; they now expect the economy will grow 6.5%. They expected the unemployment rate to fall to 5%; now they expect it will fall to 4.5%. Lastly, they anticipated inflation of 1.8% for 2021 in December; now it’s March and they expect inflation of 2.4%. That’s a 33% increase! Projections like this in the past would have surely moved the Fed to dial back guidance, discontinue QE and perhaps even queue up rate increases. But not this Fed, and not this go-round. Powell repeatedly asserted that policy wouldn’t change until its full employment and price stability objectives are ACHIEVED, not ANTICIPATED. In Powell’s words (with my emphasis):
With regard to interest rates, we continue to expect it will be appropriate to maintain the current 0-.25% target range for the federal funds rate UNTIL labor market conditions have reached levels consistent with the Committee’s assessment of MAXIMUM EMPLOYMENT and INFLATION has risen to 2% and is on track to moderately EXCEED 2% FOR SOME TIME. And that’s ACTUAL progress, not FORECAST progress. And that’s a difference from our past approach… and I think it will take people time to adjust to that. And adjust to that NEW practice. And the only way we can build credibility of that is by DOING IT.
Fortunately, the Fed’s newfound commitment to hard data and not soft projections makes our job easier. No Fed-casting necessary! Almost. What Powell wouldn’t reveal was the precise unemployment rate depicting maximum employment or the duration of 2%+ inflation required to DO IT. But we can draw some inferences from the projections. For 2023, the Fed anticipates a US unemployment rate of 3.5%. It also projects that the federal funds rate will remain unchanged at 0-.25% at that time. Since WWII, the US has had an unemployment rate of 3.5% or below only 6% of the time. Clearly, the definition of maximum employment has changed if the Fed predicts no rate increases at that level. Powell explains:
There was a time when there was a tight connection between unemployment and inflation. That time is LONG GONE.
OK, so we can infer that maximum employment means less than 3.5%. What about inflation above 2% for some time? According to the Fed’s projections, while we may see 2.4% inflation this year, inflation will recede back to 2% next year as supply catches up with demand. The Fed predicts inflation of 2.1% for 2023 and only 2.0% in the longer run, well beneath its criteria for raising rates. In fact, according to Powell, we may never see inflation again:
I would say that, again, we have been struggling with disinflationary forces for some time. If you look around the world—look in Western Europe, look at Japan—around the world, large economies have, have felt much more downward pressure on inflation, have fallen short of their inflation goals, for some time now. That is the broad global macroeconomic context that we all live in.
The kind of troubling inflation that people like me grew up with seems, seems FAR AWAY and UNLIKELY in both the domestic and global context that we’ve been in for some time.
So, if maximum employment will not lead to rate increases and inflation remains muted forever, what about the risks propagated by perpetually low interest rates?
I would point out that over the long expansion, the longest in US history (2009-2020), rates were very low. They were zero for you know, SEVEN YEARS. And then never got above 2.4%, roughly. During that time we didn’t actually see an excess buildup of debt. We didn’t see asset prices form into bubbles that would threaten the progress of the economy… the connection between low rates and the kind of financial instability issues is JUST NOT AS TIGHT AS PEOPLE THINK IT IS.
There you have it. The Fed has exited the field and will only return when the unemployment rate falls somewhere beneath 3.5% and inflation rises above 2% for an extended period, or in the unlikely event they need to correct irrational marketplace exuberances. According to Jerome Powell, we have economically turned Japanese. PROJECTED, until PROVEN otherwise.