The Capital Note

Fed Will Maintain Asset Purchases until Employment Recovers

Federal Reserve Chairman Jerome Powell speaks to reporters during a news conference in Washington, D.C., March 3, 2020. (Kevin Lamarque/Reuters)

Welcome to the Capital Note, a newsletter about business, finance, and economics. On the menu today: FOMC December meeting, the dollar’s global-reserve status, a theory of IPO pops, and a look at yield-curve control in the mid 20th century.

FOMC December Meeting
The Federal Reserve Open Markets Committee (FOMC) announced today that it would continue asset purchases at the current rate of $120 billion a month while holding interest rates at zero until at least 2023. Coinciding with progress in congressional stimulus negotiations, the announcement highlights the ongoing uncertainty of the near-term economic outlook.

While the economy has swiftly bounced back from the unprecedented contract earlier this year, recent data have revealed some fissures. Retail sales fell over the past two months, while unemployment claims increased after steady declines.

After martialing the policy response to the COVID-19 recession, the Fed now faces the challenge of convincing markets that it will maintain an accommodative stance through the recovery. In August, the FOMC adopted an average inflation target (AIT), an approach that allows inflation to surpass its 2 percent target during recoveries in order to “make up” for lost growth.

As part of that strategy, the Fed is projecting zero interest rates until at least 2023. With the zero-lower bound constraining the Fed’s ability to ease monetary policy using the federal funds rate, forward guidance on rates can encourage lending by increasing inflation expectations.

Yet markets are not convinced: Options prices imply a “liftoff” in the federal funds rate well before the FOMC’s projections, an expectation corroborated by survey data. That’s partially due to the belief that once inflation materializes, the Fed will be hard pressed to hold rates down. Even the Fed’s own projections do not show inflation exceeding 2 percent.

For that reason, many observers expected the Fed to extend the “weighted average maturity” (WAM) of its asset-purchase program. Buying longer-dated Treasuries can hold down long-term interest rates and stimulate credit growth. While that would likely not have a significant effect on credit conditions in the immediate future, it would reinforce the central bank’s commitment to accommodative policy over the long term. The Fed’s decision to keep purchases concentrated in short-maturity assets defies the expectations of many market participants, putting more pressure on Congress to finalize a stimulus deal.

The Fed did, however, provide some clarity on asset purchases by announcing that it would continue “until substantial further progress has been made toward the Committee’s maximum employment and price stability goals.” This guidance should quell fears of another “taper tantrum” — a reference to market stress following the suspension of QE in 2013 — but its imprecise language gives the FOMC plenty of wiggle room to adjust asset purchases in the future.

As the Fed transitions from crisis-aversion to cyclical easing (from “stabilization to accommodation,” as Fed governor Lael Brainard put it), its foremost priority is to bolster the credibility of forward guidance. For now, the FOMC is holding some of its cards, refraining from major policy changes while passing the baton to Congress.

Around the Web
Recent declines in the trade-weighted U.S. dollar are leading some observers to predict the end of the dollar’s global-reserve status. In the Financial Times, economist Barry Eichengreen argues otherwise:

US public saving may have fallen but private saving has risen. Part of this increase is a temporary lockdown effect: it’s hard to spend on holidays and dining out while quarantined. But another part is likely to persist. American households have been reminded of the inadequacy of their precautionary saving. Not being able to pay the rent after only four weeks out of work is a wake-up call.

We know this from history. US savings rates went up and stayed up as a result of the Depression. Individuals who experienced that searing episode at first hand remained more financially and economically conservative for the balance of their lives. Covid-19 now may well have an analogous effect.

Airbnb’s share priced double the day it went public. DoorDash jumped 86 percent on its IPO. Did their bankers rip them off? Not necessarily, says Tyler Cowen:

On IPO day, each prospective buyer is wondering what the shares will be worth, and to a great extent looking to the judgment of the other investors. A buyer might start the day willing to pay $60 a share, but upon seeing that many others are willing to pay more, maybe she will, too. It is like Keynes’s famed “beauty contest,” where investors are guessing as much about each other as about the company.

In such a setting, prices can rise or fall extremely quickly, as the very process of trading reveals information about the stock’s value. That in turn makes it possible for the share price to soar on the first day of trading, creating the “pop.”

Random Walk
As we evaluate the potential for central-bank purchases of long-term Treasuries, mid-20th century Fed policy offers a case study. A 2003 FOMC note gives background:

During the nine-year period from early 1942 until the Treasury-Federal Reserve Accord of 1951, the yield on long-term Treasury bonds was capped at 2½ percent, and ceilings were also imposed at several other points along the yield curve. In addition, the yield on short-term Treasury bills was pegged at 3 /8 percent up until July 1947. . . .

Maintaining a pattern of interest rates inconsistent with market expectations about near-term monetary policy led to large shifts in the composition of private-sector and Federal Reserve portfolios. Prior to 1947, when the bill rate was pegged at a very low level relative to bond rates, private investors abandoned bills and accumulated bonds, while the System did the opposite. The July 1947 increase in the bill rate put pressure on the 2½ percent cap on bond yields, forcing the System to accumulate a large volume of long-term bonds in order to enforce the cap.

The obligation to maintain the interest rate caps interfered with the Federal Reserve’s pursuit of its monetary policy objectives on numerous occasions, particularly during the economic expansion accompanying the onset of the Korean War. The recognition that the caps could not be maintained without exacerbating inflationary pressures eventually led to the Treasury-Federal Reserve Accord of 1951, which (among other things) discontinued the interest rate ceilings.

— D.T.

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