The two-day FOMC meeting starts today and wraps up Wednesday afternoon. While no policy changes are expected, we highlight what the Fed may or may not do. We expect a dovish hold that should weigh on the dollar, with Powell underscoring the ultra-dovish message he sent at Jackson Hole.
Powell will face many questions tomorrow about the Fed’s Framework Review that he unveiled at Jackson Hole. The change in policy was formalized (a bit earlier than expected) in its statement on Longer-Run Goals and Monetary Policy Strategy. The FOMC now “seeks to achieve inflation that averages 2% over time.” The Fed will focus on “shortfalls” in employment from its maximum level, rather than “deviations” as previously stated. To us, this is another nail in the coffin of the Phillips Curve, meaning the Fed is no longer as worried about wage pressures when the economy approaches full employment.
By moving to average inflation targeting, we feel the Fed has further muddied the waters. Yes, it’s a clear signal is that rates will stay lower for longer, but markets are left wondering under what conditions the Fed will begin tightening. Powell downplayed any sort of explicit reaction function (a la the Taylor rule), instead stressing “Our decisions about appropriate monetary policy will continue to reflect a broad array of considerations and will not be dictated by any formula.”
Because of this uncertainty over when the Fed will feel compelled to tighten, the debate surrounding the Fed’s new long-term policy statement will continue for months, if not years. Yet tolerating higher inflation is quite different from creating it. With slack in the labor market and the broader economy to remain for years, it’s hard to see where sustainably higher inflation will come from.
The bottom line is that US rates will stay lower for longer, but the risk of a policy mistake will rise as the economy approaches full employment. While most market participants (us included) are not expecting a quick resurgence of inflation, there are plenty of reasons not to be dogmatic about it (hint: massive fiscal and monetary stimulus). Indeed, the moves in real rates, inflation protected bonds, and precious metals reflects the demand for hedging the possibility of being wrong on inflation. Investors around the world have been buying up debt at low or negative yields in part due to the assumption that inflation is basically dead. By extension, we think there is a chance that the Fed will have to revise or refine its new approach in order to limit bond market dislocations as circumstances evolve. However, this is a longer-term issue that may fall upon Powell’s successor to address.
WHAT ELSE CAN THE FED DO?
Despite the aggressive measures taken by the Fed so far, it still has other tools at its disposal. Here, we look at several macro moves that the Fed could make in the coming months if needed.
- Tweak its forward guidance – LIKELY NOW. The change in the Fed’s statement on Longer-Run Goals and Monetary Policy Strategy unveiled at Jackson Hole could necessitate a slight tweak to the Fed’s forward guidance. All year, the FOMC has said “In determining the timing and size of future adjustments to the stance of monetary policy, the Committee will assess realized and expected economic conditions relative to its maximum employment objective and its symmetric 2 percent inflation objective.” With its move to average inflation targeting, the meeting statement will have to somehow acknowledge this whilst underscoring that rates will be kept lower for longer than under the previous framework.
- Tweak its macro forecasts – POSSIBLE NOW. The Fed typically adds a year to its projections at the September meetings, which means 2023 now comes into focus. At the June meeting, the Fed signaled steady rates through 2022, with two dissents looking for higher rates. We expect the new Dot Plot to extend the no rate hike view into 2023, though some dissents are possible. The median GDP forecasts from June were -6.5% in 2020, 5.0% in 2021, and 3.5% in 2022, while the median core PCE forecasts were 1.0% in 2020, 1.5% in 2021, and 1.7% in 2022. With regards to the growth and inflation forecasts, we do not expect significant changes given the current uncertainty about fiscal stimulus and the headwinds coming from the still-high virus numbers.
- Tweak existing asset purchase programs – POSSIBLE ANY TIME. As we’ve seen since March, the Fed is no longer constrained by the calendar in terms of taking policy action. For now, metrics suggest that most asset markets are functioning more or less “normally.” If any distortions or dislocations crop up, we can be sure the Fed will act quickly to address them. That said, we do not think that the Fed will add more stimulus as long as Congress is unable to come up with the next round of fiscal stimulus. That is, the Fed does not want to take any pressure off of Congress to act.
- Introduce Yield Curve Control – VERY UNLIKELY. New York Fed President Williams said recently that the Fed is “thinking very hard” about Yield Curve Control. However, Cleveland Fed President Mester pushed back a bit and said she doesn’t think the Fed is close to trying YCC whilst admitting it is “a tool I think it’s worthwhile thinking about.” Both are voters this year. The 10-year yield is currently around 0.90%, the highest since March 20. We do not think the Fed will be happy with the steepening yield curve and may offer some pushback this week. If perceived improvements in the US economy push US yields significantly higher, then we think YCC becomes more likely. It’s worth noting that countries such as Australia are having relatively favorable outcomes with YCC, allowing them to reduce their QE purchases.
- Negative interest rates – VERY UNLIKELY. Not one current FOMC member has advocated negative interest rates. Indeed, minutes from recent FOMC meetings show that the concept isn’t even being actively discussed. Uber-dove and former Minneapolis Fe d President Kocherlakota is the only Fed official that we can recall (past or present) that has advocated for negative rates. With the economy seemingly on the mend, the case for negative rates has gotten even weaker.
The dollar tends to weaken on recent FOMC decision days. In 2019, DXY weakened on 5 of the 8 FOMC meeting days. In 2020, DXY has weakened on every FOMC decision day so far, a streak of nine that dates back to October 2019. Stocks are a different matter during that same stretch, with the S&P rising five times and falling four times. MSCI EM has the same record (five gains, four losses), while MSCI EM FX has fared slightly better (six gains and three losses). Lastly, both US 2- and 10-year yields have never risen on those occasions.
Given the momentum and the stars that are now aligned against the dollar, DXY looks likely to move lower. A clean break below the 92.50 area is needed to set up a test of the September 1 low near 91.746. Similarly, the euro needs to break above the $1.1910 area to set up a test of its recent high near $1.2010. After that, charts point to a test of the 2018 high near $1.2555. That would be equivalent to DXY testing its February 2018 low near 88.253. That is as far as we will go right now, as we are reluctant to call for a broader dollar downturn just yet.
Taking a longer perspective, we note the dollar typically does poorly at the onset of each round of QE before recovering. Looking back to the financial crisis, the Fed first started Quantitative Easing (QE) in November 2008 when it announced plans to purchase $600 bln of agency mortgage-backed securities (MBS). DXY fell around 12% over the next month but then recovered to trade even higher by March 2009. QE1 was extended in March 2009 with another round of agency MBS purchases worth $750 bln as well as $300 bln worth of longer-dated US Treasuries. DXY fell around 17% over the next eight months but then recovered nearly all its losses by June 2010.
This time around, the Fed announced unlimited QE on Monday March 23. It’s not a coincidence that the dollar peaked the previous Friday, with DXY putting in a cyclical top near 103. Since then, DXY has fallen nearly 10%. The euro bottomed on March 23 near $1.0635 and has since climbed nearly 12%. Sterling had done even better, climbing nearly 18% from its March 20 low near $1.1410 to the September 1 peak near $1.35 before giving up some of those gains and is up only 13% now.
What usually turns the dollar around after subsequent bouts of QE is the recovery in the US economy. We are not getting that now due to the failure here to control the virus that has kept large swathes of the country from fully reopening. If and when the virus is better controlled, that is when the dollar could stage a recovery. But we are nowhere near that yet.