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December 16, 2020

The Fed Navigates a Tricky Meeting

By John L. Bellows, PhD

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The Federal Open Market Committee (FOMC) found itself in a tricky spot at today’s meeting. On the one hand, current economic conditions have deteriorated since the Committee last met six weeks ago. The sharp increase in claims for unemployment insurance suggest layoffs likely now outpace hires, which could make December the first month of contraction in nonfarm employment since April. Data from retail sales in November also suggest a slowdown in activity, as does the recent softening in manufacturing surveys. Covid cases are still rising in many parts of the country, causing some local officials to increase restrictions on mobility, and a further decline in economic activity is possible in the coming months. Today the FOMC undoubtedly spent a considerable amount of time discussing this worrisome confluence of current events.

On the other hand, the medium-term outlook for the US economy has brightened somewhat since the FOMC last met, due to the announcement and subsequent rollout of effective COVID-19 vaccines. These vaccines are truly a “gamechanger” that provide welcome reassurance for everybody, FOMC officials included. Financial markets are relentlessly forward-looking, so it is unsurprising that they have responded positively to the vaccine announcements. Over the past six weeks financial conditions have eased through a combination of higher prices for risk assets, higher inflation expectations and a depreciation of the US dollar.

The contrasts between worrisome current conditions and the brighter medium-term outlook likely made for an unusually lively discussion at today’s meeting. It would have been understandable if the FOMC had decided to add accommodation today. Throughout this year the FOMC has proven itself to be both aggressive and pre-emptive in responding to the ongoing economic crisis. Announcing further accommodation today would have been in keeping with that record.

The case for more accommodation was not totally straightforward, however, as there is widespread agreement that monetary policy is not the best tool to address the Covid-induced slowdown in economic activity. The fiscal stimulus currently making its way through Congress would be a preferable solution, as FOMC officials have consistently argued over the last few months. Two other arguments were likely made at today’s meeting: First, monetary policy notoriously acts with “long and variable lags.” The shutdowns may already be waning by the time further easing would affect the economy. Second, monetary policy works through financial conditions, which are already loose as a result of the forward-looking nature of markets.

In any event, the FOMC decided to hold off on providing more accommodation at today’s meeting. In particular, the Committee decided to maintain the parameters regarding its asset purchase program at its previous levels, and made only minimal changes to its forecasts and post-meeting statement. Rather than increasing either the size or the impact of the asset purchases, either of which would have been interpreted as an attempt to add accommodation, the FOMC instead provided new guidance that the purchases will be ongoing until “substantial progress” has been made toward the goals of stable prices and maximum employment. At the margin, this new language regarding “substantial progress” suggests an extended horizon for asset purchases, and therefore may be reassuring to anybody who was worried about a premature curtailment of accommodation.

Even as the decision today was to refrain from providing more accommodation, it would be incorrect to conclude that the FOMC has turned hawkish. Far from it. Instead, Chair Powell was very forceful in reiterating the FOMC’s commitment to supporting the economy with accommodative policy throughout the anticipated recovery. Indeed, the case for continued support is very strong. The Covid crisis has likely caused a substantial amount of scarring, most notably in the labor market where layoffs have led to a deterioration in skills and networks that will slow the return to full employment. The large decline in economic activity this year has also led to a substantial output gap, which will weigh on inflation for many quarters to come. The FOMC has been very clear that it will provide accommodation as long as is necessary for the labor market to return to full employment and for inflation to return to and exceed the 2% goal. Chair Powell’s message on this point—emphasizing determination and an unwavering commitment to provide accommodation as long as it is needed—was the most important takeaway from today’s meeting, and indeed will likely be the most important takeaway from the FOMC for many more meetings to come.

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