As was widely expected, the U.S. Federal Reserve held its target policy rate range steady at this week’s meeting. While the Fed did announce a small change to the interest it pays on excess reserves, this was simply fine-tuning the transmission of monetary policy to broader money markets and the economy. Also as expected, the Fed made only limited changes to the FOMC (Federal Open Market Committee) statement to reflect changes in economic data.
With limited changes to the Fed statement and no change in rates, attention turned to Chairman Powell’s press conference to provide some detail on this week’s discussions. Ahead of the meeting, we expected the focus to be on two key areas: 1) the conditions under which it would be appropriate to cut or hike interest rates, and 2) the appropriate composition of securities holdings in the central bank’s System Open Market Account (SOMA).
We didn’t learn a great deal on either topic. Though Powell was asked about rate cuts several times, the chairman remained upbeat on the economic outlook, pointed to various transitory factors that have recently negatively affected core PCE inflation (personal consumption expenditures – the Fed’s preferred inflation measure), and reaffirmed his prior statements that the current stance of policy is appropriate. Separately, he said that persistently below-target inflation would be something that the Fed would take into account, but he wouldn’t provide concrete details on how the Fed would take it into account. Meanwhile, on the question of the composition of the balance sheet, he relayed the FOMC likely wouldn’t make a decision until later this year.
Overall, a quiet and unsurprising FOMC statement belies the important policy discussions and decisions ongoing at the Fed. Our view remains that absent a more material slowing in economic growth, there’s a high hurdle for any changes in the policy rate for the remainder of this year. But the central bank is concerned about persistently low inflation, and in the meetings ahead could provide additional clarity on the appropriate policy steps in the event that inflation remains persistently below their target.
Rate cuts: whether and when?
Over the last several meetings, the Fed has communicated that it expects a prolonged period of steady interest rates, but is prepared to adjust rates up or down as warranted by the evolving economic outlook. Various FOMC participants have publicly provided additional details on the conditions that might warrant further interest rate adjustments, including cuts. However, this discussion has been absent from the minutes, leading us to anticipate some discussion at this week’s meeting or in near-future meetings.
The policymakers’ arguments for cutting rates fall into two camps. First, a rate cut could be a reaction to some negative economic shock that weighs on the growth outlook. Vice Chair Rich Clarida recently noted the Fed’s easing measures in reaction to the 1998 Russian default and collapse of Long-Term Capital Management, the 2011–2013 eurozone recession, and the 2015–2016 Chinese currency depreciation and capital flight episode. We believe many if not most FOMC participants would probably favor preemptively cutting interest rates if they judge the risks to the U.S. outlook as tilted to the downside, even if they didn’t expect a recession. If this strategy ultimately avoids rates reaching the zero or “effective” lower bound, it could be the “less risky” approach.
The second argument is that monetary policy is already restrictive. Given the wide confidence bands around estimates for the real neutral interest rate, it’s possible that a fed funds rate of 2.25%–2.5% is restrictive (warranting some offsetting rate adjustment to achieve neutral policy). If that were the case, we would expect to see growth decelerate to a below-trend pace over the next year.
Where we think there is more room for debate is around how the Fed will react if U.S. inflation remains stubbornly under target (its target is 2% PCE) even as real GDP growth is more or less in line with the 2.1% median Fed forecast (from March). This outlook, which is in line with PIMCO’s cyclical forecast, is for a continuation in productivity and real wage growth and only moderate inflationary pressures. In this scenario, it is not clear that the Fed needs to cut rates, because over time, continued above-trend growth should lead to higher realized inflation, but the Fed could cut if it wanted to more aggressively target higher inflation and sooner.
To be sure, there is no recent precedent for rate cuts when the output gap is closed and the economy appears to be doing well, and some observers might consider it a revolutionary policy. The potential benefits of such a dovish policy would need to be balanced against possible costs, including higher financial stability risks or climbing inflation expectations.
Pondering optimal portfolio composition
In previous communications, FOMC officials have stated a preference for an all-Treasury SOMA portfolio – the debate is around the optimal maturity composition of those Treasury holdings. Currently, the Fed is discussing the merits of three broad options: 1) orienting the weighted average maturity (WAM) of the SOMA to match the WAM of Treasuries outstanding, 2) returning the SOMA to an all-T-bill portfolio over time, or 3) some combination of the two.
Some Fed officials have argued that holding Treasury bills is preferable because it would give the Fed flexibility to announce another maturity extension program if needed to stimulate the economy. However, we think the T-bill market size constrains a policy of reinvesting all maturing proceeds into short-maturity assets. Over the next few years, Fed purchases would be offset by the increased T-bill (and coupon) issuance necessary to fund higher deficits. Beyond that horizon, however, the Fed would accumulate quite a large T-bill portfolio, which could constrain Treasury officials in the event that deficits normalize and/or they want to pursue other debt management strategies.
Another consideration is that the Fed should strive to maintain a consistent policy message across its various tools. One way the Fed’s SOMA portfolio policy affects the real economy is through anchoring or shifting market expectations about monetary policy. As a result, using the balance sheet to continue to tighten financial conditions while also arguing that policy should be neutral could create confusion and uncertainty.
Balancing the various benefits and costs of each approach, we think it’s possible the Fed will announce a combination of the first two policy options. For example, the Fed could manage reinvestments of current Treasury and mortgage-backed securities holdings to match the WAM of Treasuries outstanding, while buying and selling T-bills to manage changes in non-reserve liabilities. Under this scenario, the Fed could be buying around $100 billion in T-bills per year to manage non-reserve liability growth, and this plus other short-dated buying to match the WAM of Treasuries outstanding would leave the central bank with some room to announce another maturity extension program if economic conditions warrant it.
Although today’s meeting provided little new information on how and when the Fed might next adjust its key policy rate, or shift the composition of its portfolio holdings, we believe these topics are and will continue to be key areas of debate. This year, the Fed has embarked on a broader monetary policy strategy review. Although Vice Chair Rich Clarida has said the review will likely produce evolutionary instead of revolutionary policy, there remains the broader question of just how far the Fed is willing to go to achieve its inflation objective.
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