Federal Reserve officials are debating the next phase of their stimulus efforts as the U.S. economic outlook is clouded by ongoing inaction on Capitol Hill.
Although some changes are possible, the U.S. central bank is unlikely to roll out major policy shifts at its Sept. 15-16 policy meeting. The gathering comes amid signs that the U.S. economy is recovering quicker than expected, a fact that analysts say gives Fed officials more time to agree on their next steps and see what further fiscal stimulus may look like.
But analysts also warn that the continued stalemate in Congress puts the U.S. recovery at risk, potentially prompting the Fed into quicker action even as its interest rate tools are already stretched.
"The Fed is in a very tough position," said Nisha Patel, director of fixed income portfolio management at Parametric Portfolio Associates. "There's only so much monetary policy can do."
Fed officials have nudged lawmakers to approve another fiscal package, a message that Fed Chairman Jerome Powell may reiterate at his Sept. 16 news conference. He has credited Congress' fiscal action in March for its role in supporting the U.S. economy as the COVID-19 pandemic led to a historic drop in spending.
Months later, the fiscal support has helped put the U.S. in a position that is not as dire as officials once feared. The U.S. unemployment rate fell to 8.4% in August, down from a peak of 14.7% in April. Some sectors of the economy, such as residential real estate and auto sales, are booming. Retail sales have also now recovered to pre-pandemic levels.
But the services sector is expected to remain under pressure for years, and the U.S. is only about halfway to recovering the nearly 22.2 million jobs it lost after February. Fed officials have worried the progress is likely to slow from here, particularly if the coronavirus continues to surge intermittently and if fiscal support fades away.
"Given economic conditions, it seems clear that further fiscal support is needed to provide a bridge for households, small businesses, and state and local municipalities that have borne the brunt of the pandemic, until the recovery is sustainably in place," Cleveland Fed President Loretta Mester said in a Sept. 2 speech.
Two key programs that Congress approved this year have expired: a $600-per-week boost to unemployment benefits and new, forgivable small business loans under the Paycheck Protection Program.
'Dot plot' may be less gloomy
Fed officials' latest quarterly projections are likely to be less dour than they were in June, when the median forecast suggested the jobless rate would end the year at 9.3%. The forecasts, however, are still expected to show the likelihood of a slower U.S. recovery once the initial bounce-back wears off.
The "dot plot" forecasts should also reflect widespread agreement at the Fed that its benchmark interest rate will stay at near-zero for the foreseeable future. Fed officials have more or less made that clear in their public communications, but the likely projection that rates will stay flat through 2023 should underline that consensus, analysts say.
"However long it takes, we're going to be there," Powell told National Public Radio this month. "We're not going to prematurely withdraw the support that we think the economy needs."
Markets appear to be on board with that message, with the New York Fed's July Survey of Market Participants showing they do not view a rate hike as likely until at least 2023. Investors are less convinced that the Fed's ultra-dovish policy will result in a return to 2% inflation — much less the moderate overshoot of 2% that Fed officials are aiming for under their new framework.
The Fed made a historic change to its approach to targeting 2% inflation last month, which consists of officials keeping rates lower for a longer period so inflation can track a bit above 2% to compensate for the time it spent below the target.
The central bank's preferred inflation gauge — the core personal consumption expenditures price index, which excludes food and energy prices — rose by 1.3% year over year in July.
Bond market investors also seem skeptical that inflation will return to target anytime soon. The five-year breakeven inflation rate, a gauge that measures bond markets' expectations of average inflation over the next five years, was at 1.53% as of Sept. 11.
More action on tap?
Investors' skepticism suggests that the Fed may need to back up its talk of inflation tolerance with more "concrete actions," according to Aneta Markowska, chief financial economist at Jefferies LLC.
"Maintaining a policy status quo in this context would be akin to throwing in a towel, which would undermine the credibility of the new framework right out of the gate," Markowska wrote in a note to clients.
One change the Fed could opt for is laying out more explicit "forward guidance" on how long officials plan to keep their benchmark federal funds rate at effectively 0%. But Fed officials have disagreed on the best approach to make their policy guidance more clear, and the markets' continued pricing of ultra-low rates may make some officials hesitant about whether they need to clarify their approach immediately.
San Francisco Fed President Mary Daly, for example, told reporters this month that she does not "see a pressing need" to re-align markets' expectations of Fed policy.
Fed officials are also likely to discuss whether they should shift the rationale for their ongoing purchases of Treasury securities. The central bank has been buying $80 billion a month in Treasurys since mid-June, a far less aggressive pace compared to earlier in the pandemic when the Treasury market was experiencing substantial disruptions.
The primary rationale for the Fed's purchases remains to primarily ensure "smooth market functioning," which Fed officials may decide to update by saying the purchases are aimed at supporting the economy through keeping rates low. The language change opens the door to shifting the Treasury purchases more toward longer-dated securities instead of shorter-term ones, given that longer-term rates are more influential in consumers' and businesses' spending decisions.
But there appears to be "little reason now" for the Fed to focus more on longer-term Treasurys, given that their yields have remained at rock-bottom levels for weeks, according to Kathy Bostjancic, chief U.S. financial economist at Oxford Economics.
"While market participants are eager for the FOMC to take immediate action following the announcement of its new framework objectives, we believe it's premature to expect any major policy announcements," she wrote in a note to clients.