The Fed Signals More Accommodation in 2021

Here’s a look at the U.S. Federal Reserve’s actions at its final policy meeting of 2020—and the implications for interest rates, inflation, an risk assets in the coming year.

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In the final policy meeting of a momentous year, the U.S. Federal Reserve (Fed) laid the groundwork for additional monetary accommodation in 2021. In the most significant policy action, detailed in a post-meeting press release on December 16, the Fed’s policy-setting arm, the Federal Open Market Committee (FOMC), pledged to “ ... continue to increase its holdings of [U.S.] Treasury securities by at least $80 billion per month and of agency mortgage-backed securities by at least $40 billion per month until substantial further progress has been made toward the Committee’s maximum employment and price stability goals...” (emphasis added).

By tying asset purchases to its so-called dual mandate, the FOMC brought quantitative easing (QE) under the same umbrella as forward guidance on short-term interest rates and the new flexible average inflation targeting framework.

If the FOMC was to maintain the current pace of asset purchases until the end of 2021, its balance sheet would expand by approximately $1.5 trillion. That would be a substantial increase on top of the $2.9 trillion expansion the Fed has undertaken since mid-March. The goal of incremental purchases is to maintain both smooth market functioning and accommodative financial conditions that support an ongoing economic recovery from the disruptions caused by the COVID-19 virus.

In a post-meeting press conference, Fed Chair Jerome Powell mentioned that the FOMC will inform the public “well in advance” of any tapering of asset purchases. Since it has already been announced that tapering of asset purchases including, presumably, a period of balance sheet stability, will precede any interest rate increases, it appears reasonable that rates will remain at the current level until at least mid-2023, as is embedded in market prices.

Powell noted that maturity extension of the Fed’s portfolio was discussed at the November 2020 FOMC meeting. To be sure, such a move is not high on the list of possibilities for additional modifications to the Fed’s current policy settings. But Powell said that it was part of the toolkit the Fed has at its disposal—along with additional rate guidance and more aggressive QE—should additional accommodation be required.

Additional Takeaways
We think there were some interesting additional nuances in his statement before the press conference that suggested flexible average inflation targeting, the new operating procedure the FOMC formally adopted in September, really does need to be understood as a significant regime change.

• Powell stated that policy will remain highly accommodative for a long time, until the goals of maximum employment and (sustainable) 2% average inflation are nearly reached, which is not the way it has been done in the past.
• He said that if pent-up demand for services leads to a burst of price increases in 2021 that this would be viewed as transient, i.e. not an indication that inflation had increased sustainably.
• He appears to be benchmarking the labor market to the state the economy was in immediately prior to the pandemic—sub-4% unemployment—as a guide for whether maximum employment was close at hand.

Policy and Investment Implications

There was no hint that the FOMC is in any way uneasy about maintaining low rates for an indefinite period due to financial stability considerations or that it has any qualms about ongoing aggressive balance sheet expansion for an indefinite period if that is required to maintain accommodative financial conditions. It adds up to a policy stance that is highly supportive of risk asset prices and promises to remain so until inflation accelerates to 2% sustainably, a condition that we believe may not come to pass for many years.
 

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This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Fed refers to the U.S. Federal Reserve.

Quantitative easing (QE) is a form of unconventional monetary policy in which a central bank purchases longer-term securities from the open market in order to increase the money supply and encourage lending and investment.

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