Is anything left in the Federal Reserve war chest?
After its August 27th meeting, the Federal Reserve announced its Statement on Longer-Run Goals and Monetary Policy Strategy, which provides a backdrop for its quick response to the economic and financial trauma arising from the coronavirus pandemic.
The increased focus on promoting job and wage growth, beyond any consensus "full employment" metric, reflects the Fed's concern that lower-income segments of the economy will realize greater job and wage growth benefits later in the economic expansion.
Why is this unprecedented? Past Fed priorities put inflation prevention above job growth once a metric of full employment was achieved. So, just as these late-stage benefits favoring lower-income groups started to materialize, the traditional approach was to start to tighten credit to slow economic growth pressures on inflation and rising wages.
As a prelude to this strategy shift, however, the Fed's interest rate reductions in the last half of 2019, with an already record low overall unemployment rate, validated observations about expanding job and wage growth benefits to disadvantaged employment groups.
As Fed Chair Jerome Powell advised, "our revised statement reflects our appreciation for the benefits of a strong labor market, particularly for many in low- and moderate-income communities, and that a robust job market can be sustained without causing an unwelcome increase in inflation." So it's no surprise that the most recent changes in the Federal Open Market Committee framework highlight:
• The Fed's employment goal will be on shortfalls of employment rather than deviations from an expected maximum level, beyond which inflation pressures would arise;
• The Fed's price stability goal will change from a 2% inflation rate "trigger" of Fed tightening to a 2% average over time, allowing inflation to run above 2%, with job and wage growth continuing; and
• The Fed's acknowledgment that in a lower-for-longer interest rate environment, Fed policy tools, in addition to setting short-term interest rates, will matter more and likely will expand beyond its current tool chest.
However, without first bringing the risk of serious illness or death to a very low level, government efforts to reopen the economy will fail. Fed officials have publicly stated on several occasions the importance of businesses having the confidence to reopen and households to return to the workplace and marketplace. To punctuate this point, the FOMC included in its statement after its July 28-29 meeting: "The path of the economy will depend significantly on the course of the virus."
By any metric, the Fed provided an extraordinary safety net under U.S. financial markets and the economy to mitigate the ravages of the coronavirus and efforts to contain it. Beginning in March, the Fed’s moves were pre-emptive, pro-active, and aggressive by bringing short-term interest rates to zero, adding $3 trillion to its balance sheet with an ongoing commitment to unlimited bond buying, and activating emergency credit facilities with authorized lending capacity of $2.6 trillion. They provided the principal tools for stabilizing the U.S. and global financial system, thereby preserving jobs otherwise lost in the pandemic-generated disruption.
What’s in the Fed's war chest? With its new policy framework in place, the Fed will decide how it can use its current war chest more aggressively and effectively to achieve its primary goal of increasing jobs and wage growth through a more robust economic rebound.
A likely first step is to increase its regular bond-buying program of U.S. Treasury and residential and commercial mortgage-backed securities. Its commitment to unlimited bond-buying is a good place to begin, especially with its decision not to pursue negative interest rates. The expectation that it will increase its balance sheet by another $2.4 trillion by the end of 2020 would be supportive of augmenting this direct approach.
The new policy framework would also warrant issuing stronger forward guidance — either calendar- or outcome-based — which would likely accompany a new program of large-scale asset purchases. Businesses and investors are still digesting the implications of letting inflation run higher to achieve a longer-term average of 2% after inflation has been so much lower for a longer time. Forward guidance and increased bond-buying would help provide confidence that higher interest rates from higher inflationary expectations aren't just around the corner.
The $2.6 trillion lending capacity in the existing Emergency Credit Facilities is largely untapped. While their mere existence keeps credit markets running smoothly, there is an opportunity to provide further stimulus to credit flow through these facilities.
The four most likely facilities to provide an immediate impact in supporting economic recovery, with new virus infections slowing and self-imposed shutting in abating, would be these:
• Municipal Liquidity Facility, with $500 billion in capacity, it can support cities and states in meeting the immediate needs of front-line providers of public health, medical care, and education, especially in adapting facilities to new requirements of mitigating virus exposure.
• Main Street Lending Facilities, with $600 billion in capacity, it can support small and mid-sized businesses and non-profits, including hospitals, schools, and social service organizations that were in sound financial condition before the pandemic.
• Corporate Credit Facilities, with $750 billion in capacity, it can provide direct loans to major corporate employers to allow companies access to credit, so they are better able to maintain business operations and capacity during the period of dislocations due to the pandemic.
• Primary Dealer Credit Facility, with no effective limit when collateralized, it can expand the range of financial firms that can borrow to include other institutions not currently eligible.
With the economy not yet in the self-sustaining part of the cycle and much needed fiscal stimulus still pending enactment, the Fed effectively can add $2 trillion in stimulus through these programs. With the updated FOMC policy guidelines, active education, and implementation of these programs can keep economic activity robust as pandemic risks subside. This will be an effective complement to augmenting its balance sheet and other policy tools.