With rates near zero, Fed still has a role to play

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After the COVID-19 pandemic forced non-essential business to shut, the Federal Reserve acted aggressively to cut rates to the zero lower bound and introduce other programs to keep money flowing, and its leaders continue to promise to use all tools to support the economy.

No one expects any change to the fed funds rate target when the Federal Open Market Committee meets on Wednesday and Thursday (pushed back a day from its usual Tuesday and Wednesday pattern because of Election Day), but that doesn’t mean there’s nothing to watch for.

“With chaos and uncertainty stemming from the presidential election and ongoing negotiations over a potential fifth round stimulus package, the onus falls on the Fed to provide much needed calm and implied support to the market,” said Stifel Chief Economist Lindsey Piegza. It “is likely to amp up its rhetoric reiterating its intention to remain accommodative.”

In his post-meeting press conference Chair Jerome Powell “is likely to offer assurances that while the infighting may continue in Washington, the Fed is standing ready to deploy any additional monies or credit needed to keep market functioning smoothly.”

Also, he is apt to press Congress for more aid, “for fear of dire economic consequences should further stimulus be denied the American people and businesses still reeling from the pandemic,” Piegza said.

Hank Smith, head of investment strategy at The Haverford Trust Company, agreed Powell “will reiterate the need for more fiscal stimulus. This is a recent departure for the Fed, which typically focuses on its ‘lane,’ which of course is monetary policy. We can’t remember a previous Fed chairman opining on fiscal policy, other than perhaps answering questions on the unsustainably high debt levels.

But the panel “has consistently underestimated the strength of the economic recovery,” since the late spring, he said. ”Will they acknowledge the economy is doing better than they expected, while at the same time urge Congress to pass another round of stimulus? The recent spike in COVID-19 cases certainly gives them cover to request more fiscal stimulus.”

The markets are concerned that the rise in COVID-19 cases could force “draconian lockdowns, like last spring’s, which will impede the economic recovery,” Smith said. “It will be interesting if Jay Powell comments on the economic (and health) impact of lockdowns.”

Kevin Philip, managing director at Bel Air Investment Advisors, agreed the panel will urge additional fiscal stimulus. "It is no secret the Fed is running light on additional tools; interest rates are close to negative, its lending programs are in place, and they’ve announced an approach to inflation that targets an average level, allowing for periods of higher levels of inflation to run ‘hot’ to compensate for times of lower inflation.”

"It is no secret the Fed is running light on additional tools," said Kevin Philip, managing director at Bel Air Investment Advisors.

And expect a “non-partisan” tone, whether the election has been decided or not, he said. “The Fed will try to balance supportive comments on the economy with its perception that the U.S. economy is in the ICU and only feels OK because of a historic dose of adrenaline administered earlier this year that is fast running out."

Ian Seaver, investment director-fixed income at Hartford Funds, says to “expect a reinforcement of their commitment to stay flexible and use the tools at their disposal to maintain financial stability, particularly as the pandemic reaccelerates globally.”

He noted most Fed officials projected rates to remain near zero through 2023. “Over the next six months, markets are pricing in a very modest probability of a rate cut, however given the FOMC’s reservations about introducing negative rates, we believe that is a low probability outcome,” he said.

The Fed could, however, give details about “the trajectory of future asset purchases, but imminent changes are not expected given previous comments by the committee.” The panel committed to keeping purchases of Treasuries of at least $80 billion a month and $40 billion of mortgage-backed securities.

“However, if economic conditions deteriorate further due to an uptick in COVID-19 cases,” Seaver said, “we believe Fed officials may be more aggressive in providing further accommodation to help stifle downside impacts.”

But, Jason Brady, president and CEO at Thornburg Investment Management, noted, “some members of the FOMC are feeling queasy about the effect of Fed support in certain riskier markets, particularly in fixed income.” He mentioned Boston Fed President Eric Rosengren and Dallas Fed President Robert Kaplan.

But he believes the panel ultimately “will directly support fiscal expansion,” despite some members’ “cold feet.”

While the rate issue is settled — don’t expect any changes — “What’s not clear is the status of the other programs; if they continue, the FOMC will start to implement these ‘macro-prudential’ measures which, if effective should make markets go down and restrain risk taking.”

Brady said he’ll be looking for clues, especially from Powell’s press conference, “but with the Fed still in wait-and-see mode, we should expect the Fed policy to be fairly consistent in the next meeting.”

Markets will remain volatile, “not just because of the election,” he said, “but because we’re still dealing with a challenging market environment in which any further recovery from the recession, we are in will be slower and bumpier than the V that we’ve seen thus far.”

The Fed has limits, noted Michael White, portfolio manager at Picton Mahoney Asset Management. “The Fed cannot create growth and inspire confidence in consumers or businesses. All they can do is get out of the way, and allow credit to flow as freely as possible, but the demand and desire to take on credit risk has to be there organically,” he said.

Projecting no rate hikes before 2023, “the Fed has already pledged to stay out of the way.” With no fiscal assistance coming until after January, “the only short term policy tool left to explore is negative rates, but they have already been dismissive of going there given the questionable impact seen in Europe so far,” White said.

In data released Monday, the Institute for Supply Management’s manufacturing PMI rose to 59.3 in October from 55.4 in September. Economists polled by IFR Markets expected a 55.8 read.

The new orders index rose to 67.9 from 60.2, production gained to 63.0 from 61.0 and employment grew to 53.2 from 49.6.

Elsewhere, construction spending climbed 0.3% in September after a revised 0.8% gain in August, first reported as a 1.4% increase.

Economists expected a 0.9% rise.

Year-over-year spending is up 1.5%.

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