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  • KPB & Co Research

Summary

  • US Fed to keep the target range for the federal funds rate at 0 to 0.25%.
  • Future policy actions will depend on how the US responds to the coronavirus
  • Quantitative easing will continue to increase.
  • Low oil prices to keep inflation objective challenged.

Fed To Keep The Market Liquid

On Wednesday July 29, 2020, Fed Chair Jerome Powell announced that the federal open market committee (FOMC) elected to expand monetary policy as the country continues to grapple with the Coronavirus pandemic. The target for the Fed's key policy rate will be kept at between 0% to 0.25% following consecutive cuts since the pandemic began in February 2020. On the other hand, the Fed will also continue to increase its holdings of bonds (treasury securities, and agency residential and commercial mortgage-backed securities) at an amount that is equal to or greater than the current pace of increase.  In addition, they plan to continue to offer overnight (1 day) and term (many days) repurchase agreement (REPO) operations en-masse. 

In arriving at its decision, the committee sited two critical of factors which have negatively impacted its ability to meet its mandate of full employment and price stability. First, as expected, is the economic shutdown in response to the Coronavirus, and Second is the significant fall in oil prices. The Fed expressed concern for the continued high unemployment levels that exists even as locked down measures have eased in most regions in the US. A combination of low employment levels, and persistent low oil prices are expected to keep increases in consumer prices very low, posing a threat to Fed's ability to meet it 2% inflation target.

The Fed believes that going forward, its ability to meet its objectives will depend on the nation's success with managing the spread of the virus. According to the Fed:

The path of the economy will depend significantly on the course of the virus. The ongoing public health crisis will weigh heavily on economic activity, employment, and inflation in the near term, and poses considerable risks to the economic outlook over the medium term... The Committee will continue to monitor the implications of incoming information for the economic outlook, including information related to public health, as well as global developments and muted inflation pressures, and will use its tools and act as appropriate to support the economy.
How We Interpret Their Statement

By all indications, it appears that the Fed is making monetary conditions looser with time. The Fed's ability to effect monetary policy through rate cuts is limited by the zero bound. In this regard, the Fed has little option but to continue to use quantitative easing as its most effective monetary policy tool. The Fed outlined that they intend to keep increasing its holdings of private and government bonds at the current pace of increase (US$80Bn in treasury + US$40Bn mortgage backed securities). In addition, they are also keeping the option to increase the rate at which they expand their holdings, on top of keeping the status quo on REPO operations. This unprecedented level support is tantamount to putting monetary loosing on autopilot.

It appears that the Fed will keep monetary conditions loose going well into 2022. The Fed outlined that future policy actions will be tied primarily to the evolution of  the "public health crisis". Recent events suggest that the public health crisis will continue to have an impact going into 2021, due to the time it will take to develop a reliable vaccine. Certainly, the Fed will be looking to a range of economic measures to gauge the health of the economy:

measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.

These economic indicators will not turn positive until lockdown measures ease, and it appears that lockdown measures will not ease until a vaccine is developed. In recent times, confirmed cases of the coronavirus have surged in some states that have re-opened, leading to the re-imposition of lockdown measures. This has been the case in Florida, California, Texas, and North Carolina. In addition, there are some countries that are experiencing rising infection rates such as Brazil, and some that are experiencing a second wave such as Hong Kong, Spain, China, and the UK.

​Conclusion

Though some argue that the Fed's unprecedented monetary policy response is unsustainable, the evidence suggest that they have little alternatives. Joblessness world wide are at extraordinary levels, and as demand declines permanently, it appears that a lot of these jobs will not return quickly. In addition, central governments are now seeking ways of reducing the cash burn on the fiscal accounts, which is good for fiscal sustainability but bad but for keeping economic activity going. ​In this context, there is a high likelihood that economic conditions could get worse before it recovers, and in this scenario the Fed will have to play a key role in maintaining stability.


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