An agreement between Congress and President Trump on a relief package would make it easier for the Fed to support the economy in 2021, but a fiscal jolt will not shake the central bank's resolve in sticking with ultra-low interest rates for the foreseeable future.
Economists believed that the $900 billion fiscal deal approved by lawmakers would help stave off worries of another recession early next year. Although President Trump's last-minute request to increase payments to individuals could result in a bigger package, it has thrown the plan's future into doubt. No matter the size of the stimulus package, the Fed has cautioned a full recovery from the COVID-19 pandemic could take some time, requiring low borrowing costs to help fuel spending from consumers and businesses.
"The Fed is going to have to continue to push forward with their low interest rate policies," said Kevin Nicholson, global fixed income co-chief investment officer at RiverFront Investment Group.
The central bank will look to do so through two avenues. It will keep short-term interest rates at rock bottom by leaving its benchmark interest rate at effectively 0%, and it will provide guidance that it will stay there for the foreseeable future. In their latest forecasts, Fed officials indicated they will keep rates unchanged through 2023.
The Fed will also look to keep a lid on longer-term interest rates, as those are more influential for big consumer purchases like homes and cars. Although the Fed has less control over where long-term interest rates settle, it can nudge them down through buying up assets like Treasury securities and mortgage-backed securities.
The Fed has been conducting those purchases to the tune of $120 billion a month, but it will continue to face questions next year over whether it should adjust the program to provide more stimulus or perhaps dial it back if the recovery surprises to the upside. The Fed, for example, could choose to tilt its Treasury purchases toward more longer-dated securities to bring down long-term borrowing costs, rather than continuing to buy Treasury securities of all maturities.
Fed officials held off on making such changes at their December meeting, judging that they are providing enough support given that rates are near historical lows.
"We think we are providing very ample support for the economy with the combination of our guidance and these purchases, which are at a very, very robust pace [of] $120 billion a month," Fed Vice Chairman Richard Clarida told CNBC on Dec. 18. "We think that the current constellation of policies is exactly where we want it to be."
Housing sales, vehicle sales and other parts of the economy that are most responsive to interest rates are performing "very, very well," Fed Chairman Jerome Powell told reporters two days earlier. The main factor holding back the struggling service sector is not interest rates, but the coronavirus' continued spread, he added.
To that end, the fiscal package that lawmakers approved would help extend support for unemployed Americans and hard-hit small businesses for some time, economists say. But a critical piece of that support — a $300-per-week boost to unemployment benefits — would only last for 11 weeks and therefore could expire before mass vaccinations are rolled out in the middle of the year.
"It is possible that aid will lapse once again, even as households and businesses continue to feel the ongoing impact of virus-containment measures," according to Rubeela Farooqi, chief U.S. economist at High Frequency Economics. She wrote in a note to clients that more fiscal support will likely be needed, but its size may depend on the outcome of the Jan. 5 runoff U.S. Senate in Georgia, which will decide whether Democrats have control of both chambers of Congress.
But should the widespread issuance of the vaccine unleash massive amounts of pent-up demand from previously home-bound consumers, the Fed could face a "bit of a conundrum," said Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research. While that would accelerate the economic rebound, the Fed could eventually be forced to re-evaluate its dovish bias and promises to keep its foot on the gas if the recovery turns out to be stronger and quicker than expected, Jones said in a year-ahead outlook call with reporters.
Powell sought to downplay such concerns during his Dec. 16 news conference, saying any increases in air travel prices and other pent-up demand sources have "all the markings" of a temporary inflation increase the Fed would look beyond. The Fed will monitor those pressures "very carefully," but the dominant theme appears to be one in which inflation continues to be weaker than decades ago, Powell said.
Those disinflationary pressures were a key factor behind a historic revamp in the Fed's policy framework this August. Fed officials will now look to achieve a temporary overshoot in their 2% inflation target to roughly compensate for the time inflation has spent below it. And they will aim to achieve a "broad-based and inclusive" recovery in the labor market, ensuring job gains are widely shared before worrying about the potential for too-high inflation.
If the Fed were to begin tightening policy, it would likely start by reducing its asset purchase program rather than raising short-term interest rates, which analysts agree will stay near 0% for at least a couple more years.
Given Powell's assurance that the Fed will communicate any tapering of its asset purchases "well in advance," that could mean hints of lowering its level of purchases could start to emerge in the second half of 2021, Deutsche Bank Chief U.S. Economist Matthew Luzzetti wrote. But the actual tapering process is unlikely to begin until 2022, and the process will be "handled very cautiously" and gradually, he added.
"While the pre-virus level of activity is expected to be regained in relatively short order, lingering scars in the labor market and lagging inflation should continue to impact monetary policy for years to come," Luzzetti wrote.