Boston - As expected, there were no substantive policy changes announced at the July 27-29 Federal Open Market Committee (FOMC) meeting. The most notable news from Fed Chair Jerome Powell came during the press conference, where he put an emphasis on health policy. Although economic data had shown signs of renewed strength, the recovery has slowed over the past month.
Even more concerning, the health situation related to COVID-19 in the US had deteriorated over the same period, which could lead to an even slower recovery. Powell's clear message? Putting the focus on improving health outcomes across a variety of metrics is the best way to reignite the nation's economy.
The economic data we're getting now has been mostly surprising to the upside, largely because of the improving conditions we experienced before. If current conditions stay where they are (or deteriorate), that data will certainly worsen. So again, we are dependent on the health outcomes of the pandemic and it's essential to focus on that rather than short-term economic data.
As I've mentioned previously, the Fed is clearly in transition from its focus on the immediate aftermath of the global pandemic to a formulation of medium-term policy. The central bank dealt with the issues of market functioning and bridge finance to address the short-term effects of COVID-19. The question now is: What should our monetary policy regime be to get inflation to target and the economy growing to its potential from this point — not only until we have a vaccine available but also for the post-vaccine environment?
Getting inflation to target
The Fed was doing a lot of this work pre-COVID-19. In retrospect, it seemed fairly academic at the time, but here we are experiencing a very significant downturn. The Fed had put a considerable focus on how to address inflation, which had been (mildly) undershooting its target. Persistent inflation shortfalls carry the risk that longer-term inflation expectations become anchored below the stated inflation goal. To keep that from happening, should the Fed start to overshoot? There had been considerable debate about the Fed going to an average inflation targeting regime so if the US undershot inflation for a number of years, it could overshoot its target to maintain some equilibrium. I think the Fed is going to go to some version of that policy, although the details are not entirely clear. It may well announce a new policy at the September meeting or soon thereafter.
The Fed seems increasingly comfortable with higher inflation, as we've learned from comments from Fed Governor Lael Brainard and even Federal Reserve Bank of Philadelphia President Patrick Harker, among others.
Interest rates: Lower for longer
Those voices at the Fed have also made it very clear that they do not advocate preemptively raising rates to starve off inflation as they did during the hiking cycle that we saw from 2015 to 2018. I think the Fed is very much signaling to the market that rates will be even lower for even longer. Even if the economy starts to pick up in a year or two, the market should not even be thinking that the Fed will start raising rates.
Bottom line: The change in interest-rate policy has very little effect on the markets at the moment because no one is remotely expecting the Fed to raise rates. But looking out to a period when a vaccine is readily available, or if there is some other reason the economy begins to pick up a lot, a rate hike is off the table — at least until inflation reaches its target.