Policy Intact

As widely expected, the Federal Open Market Committee (FOMC) made no substantive changes to its policy stance during its Sept. 15-16 meeting. The committee left its target range for the fed funds rate unchanged between 0.00% and 0.25%, and it maintained its monthly purchase rate for Treasury securities and mortgage-backed securities (MBS) at $80 billion and $40 billion, respectively.

On Forward Guidance

So what are the economic benchmarks the voting committee will look for before considering increasing the federal funds rate or changing the pace of asset purchases related to quantitative easing (QE)?

On the interest rate policy, the FOMC expects to maintain the federal funds rate target at its current range until reaching "maximum employment" and until inflation has risen to its 2% target and is on track to "moderately exceed" that "for some time." On QE, the FOMC didn't provide any more guidance on the time or economic outcome dimensions other than continuation at current pace (at least) "over coming months."

During his press conference, when pressed, Chairman Jerome Powell indicated that:

• "Moderately exceed" inflation target means not very high above 2%.
• "For some time" neither means just one month nor on a sustained basis.
• "Maximum employment" is "not something that could be reduced to a number" (it doesn't just mean low unemployment rate but also other labor market indicators such as labor force participation and wages).

The explicit mention of inflation needing to reach 2% before the committee hikes rates constitutes a form of data- or outcome-based forward guidance (versus calendar-based and open-ended) (1). Still, we think the relative lack of specificity in the forward guidance leaves the FOMC with more room for discretion than preemption (and more tea leaves to read for Fed-watchers, like us).

For what it's worth, two FOMC voting members (out of currently 10)--Neel Kashkari (Minneapolis Fed) and Robert S. Kaplan (Dallas Fed)--dissented from the decision. Mr. Kashkari wanted a firmer commitment to leave policy at the current rate until inflation has reached 2% on a sustained basis, while Mr. Kaplan wanted the FOMC to maintain flexibility.

A First Step Toward Implementing A Revised Monetary Framework

Although the guidance on interest rate liftoff is still vague in many ways, the explicitly mentioned need for inflation to reach 2% and exceed it moderately for some time is a step toward implementing the revised monetary policy framework the FOMC published after its Jackson Hole meeting at the end of August.

In our last biweekly economic roundup, we wrote on the Fed's much-anticipated change to its monetary policy operational framework (see "U.S. Biweekly Economic Roundup: Job Gains Slow Amid Signs Of A Long Recovery To Come," Sept. 4, 2020). In short, the new operational framework means the Fed will not raise rates, even when unemployment rate falls below estimated NAIRU levels (approximately 4%), until inflation is above the 2% target for some time, so as to meet the target "on average" over a period of time (making up for past shortfalls from target). The Fed will instead focus on shortfalls from maximum employment--described as a "broad-based and inclusive goal that is not directly measurable and changes over time" (not just standard U3 unemployment rate)--and wait to see evidence of labor market-driven inflation before it tightens policy on those grounds (2).

This week's FOMC meeting--the first after the announcement of the new framework--left some questions about the new framework. These include what time frame to use for averaging inflation, what constitutes "moderate" overshoot of 2% inflation, and how will the employment and inflation be interpreted in policymaking if there is a conflict (such as stagflation).

That said, like other Fed governors on their speaking circuit before the meeting, Chairman Powell pointed to "regulation, supervision, high capital, high liquidity, stress testing, all of those macroprudential tools" as the first line of defense if there is a conflict between economic stability and financial market stability.

Dot Plot And Economic Forecasts Support Rates On Hold At Least Through 2023

With the unemployment rate currently at 8.4% (in August) and inflation well below 2% on a year-over-year basis--the latest core Personal Consumption Expenditures (PCE) inflation, in July, and core Consumer Price Index (CPI) inflation, in August, were 1.3% and 1.7%, respectively--the Fed is far from raising rates.

This view was buttressed by the FOMC's latest summary of economic projections, which shows that the median forecast of 17 FOMC participants for the interest rate is at zero-bound until at least 2023, even as participants lifted their real GDP and inflation forecasts and lowered their unemployment rate forecasts (see table 1). Only one FOMC participant (not necessarily one of the 10 voting members) expected a rate hike before the end of 2022, and only one sees the fed funds rate above 1% by 2023.

Table 1

What is interesting is that despite the stated goal of inflation above 2%, few participants expect it to actually do so. It is not just the median, but also the central tendency of estimates that remains below 2.0%. This suggests that a majority of members anticipate the federal funds rate to be on hold even past 2023.

At the same time, Fed officials don't see the pandemic affecting the estimates of longer-run sustainable growth, the unemployment rate, and the neutral interest rate.

A Cautious Stance On The Data Front

The overall tone of the FOMC's statement and Chairman Powell's press conference was not only dovish but also cautious.

Although the committee acknowledged "economic activity and employment have picked up in recent months," it also noted they "remain well below their levels at the beginning of the year." The FOMC also highlighted the risks to the outlook by stating that "the path of the economy will depend significantly on the course of the virus," which is unknowable at this time.

And we think the evolution of data supports their caution. Although various economic metrics showed an early burst through the gates in the current recovery, there are signs that momentum is slowing. The New York Fed's Weekly Economic Index--a composite of 10 daily and weekly indicators of real economic activity, scaled to align with the four-quarter GDP growth rate--has moved sideways since the end of August after having recovered about halfway (see chart 1). In tandem, the Conference Board's Leading Economic Indicators Index decelerated to 1.2% in August, from 2% in July and 3.1% in June.

Chart 1

Recovery has been uneven, with core goods consumption having recovered fully to the pre-pandemic levels. The return to normal levels is likely to bring about fading growth momentum in the goods sector, and the burden of growth will be squarely on the services sector, which remains well under normal levels because of virus fears and capacity constraints. Negative shock looms from the expiration of unemployment benefits by the end of this month as the window for negotiating another relief bill may be starting to close.

The U.S. retail sales are above their pre-pandemic levels (helped in part by the government income assistance to the unemployed), but the growth pace has moderated--to +0.6% month over month in August from +0.9% month over month in July. Control retail sales (excludes gasoline stations, food services and drinking places, building materials, and auto sales), which factor directly into GDP, declined by 0.1% month over month in August and were revised lower to an increase of 0.9% in July from the initial estimate of +1.4% month over month (see chart 2). We expect monthly gains to remain modest from here on out as the return to normal dynamics sets in.

Chart 2

On the other hand, industrial production in the manufacturing sector still lags in this recovery--it remains at half the level of where it was before the pandemic (see chart 3). The inventory-to-sales ratio is at a historically low point, so the inventory cycle is favorable to manufacturing activity in the near term (all else constant) (see chart 4).

Chart 3

Chart 4

The housing market has been a bright spot during the recovery and one important way that this recovery has been different from the previous one. The strong construction rebound, from pent-up demand, coming out of the lockdown period showed signs of cooling in August (from a high level). Construction for single-family homes is continuing at a solid pace, still, while multifamily starts are weakening (see chart 5). Single-family housing activity tends to have a very favorable multiplier effect across the broader economy. As long as this market is holding together--and even though there will be a fading direct contribution to growth from here out given that it has come back to its pre-pandemic levels--it's a positive sign for the overall picture.

Chart 5

Table 2

Table 3

Endnotes

(1) Calendar-based forward guidance is a policy path with an explicit reference to a calendar date. An example would be something like "policy rates are expected to remain at their present levels at least through the first half of 2023." Open-ended forward guidance is a purely qualitative statement about the policy path. An example would be something like "policy rates are expected to remain at their present levels for an extended period of time."

(2) The new inflation strategy is known as Flexible Average Inflation Targeting (FAIT). The previous inflation strategy, since 2012, is a form of Flexible Inflation Targeting (FIT): 2% inflation was a goal, balanced per the dual mandate with minimizing deviations from NAIRU. Past misses of 2% inflation were not considered. The new framework emphasizes that 2% is not a ceiling and that bygones are not bygones, as the FOMC now "seeks to achieve inflation that averages 2% over time." Following periods when inflation has been running "persistently below 2%", it would seek to promote inflation "moderately above 2% for some time." Monetary policy would seek to achieve inflation averaging near 2% by allowing inflation to diverge "moderately" and "over time" from the 2% longer-run objective to offset, in approximate fashion, for previous misses in the other direction.