The Federal Reserve won’t be happy with what it sees when it looks at the economic outlook, but isn’t ready to pull the trigger on any major policy changes, at least not yet.
“The Fed is not ready to make radical changes or aggressive changes here,” said Ethan Harris, the head of global economic research at Bank of America, in an interview.
Fed officials will gather for two days of talks beginning Tuesday. Little is expected to be announced publicly beyond continued emphasis on a dovish policy stance, said Robert Perli, head of global policy at Cornerstone Macro.
There is talk that the Fed is preparing to publicly pledge to keep rates at zero until inflation reaches or moves above its 2% target. But that’s pretty thin gruel and no surprise to Fed watchers, who widely think the Fed has had that policy in place since early last year.
Fed Chairman Jerome Powell will hold a press conference at 2:30 p.m. Wednesday.
At the beginning of the crisis in mid-March, Fed officials said July 1 might be a good time to assess the initial health of the economy after the blow from the coronavirus pandemic.
So what is the Fed seeing?
After two months of signs of a rebound in May and June, real-time data suggests the U.S. economy is stalling. There has been an upsurge in COVID-19 infections, and that appears to be weighing on growth.
It is dawning on everyone that “to constrain the virus, in addition to masks, you have to maintain some limits on economic activity,” said Avery Shenfeld, an economist at CIBC.
A substantially weaker economic outcome is just about as likely as their “base-case” of a slow and steadily improving economy, according to the Fed staff.
Fed policy has already been forced into a situation where it’s nursing along some companies and businesses that in normal times would have gone under. Market discipline has evaporated. In addition, a big chunk of the population is on financial life-support from the government, Harris noted.
“At least for the duration of this crisis, we’re basically a socialist economy,” he said.
Fiscal policy at the moment is more important than more dovish talk from the Fed.
What would get the Fed off the sidelines? Evidence that it is losing the battle against inflation, Harris said. While that’s not apparent yet, Harris thinks it’s a matter of time.
The Fed’s best remaining policy option under these circumstances would be to peg the interest rates on the U.S. 10-year Treasury note, Harris said. This is called “yield-curve control.”
“I think there is a good chance that it comes at some point, either in the fall if the economy doesn’t pick up, or some point down the road,” Harris said. “Yield-curve control is much easier than trying to fiddle around with QE, and is the one macro tool that would show a significant step forward,” he said.
Fed officials have been talking about yield-curve control over the past few weeks, but mainly at the short end of the yield curve. Pegging shorter-term rates would be inconsequential, Harris said.
Doing so at the longer end is a more serious step, but that is where there’s room to push down rates, Harris noted.
Harris thinks the Fed can peg the 10-year in a low-rate environment. “No one is going to challenge the Fed on that,” he said.
If the economy is still wounded, then the next tool would be for the central bank to engineer direct purchases of equities, although the market is doing fine without it, Harris said. That would set off a firestorm of criticism, though that isn’t likely to deter the Fed.
“All of these things seem kind of crazy until you’re in a position that you have nothing left,” Harris said.
“I think what happens to every central bank when they start to get into the bottom of their tool-kit, they start holding their nose and introducing things. They realize that to do nothing, or admit that you could do nothing, is even worse than adopting a policy that is unpopular and may not even be that effective,” he said.
The 10-year Treasury yield TMUBMUSD10Y, 0.576% has recently been stuck in a trading range close between 0.6% and 0.9% over the past few months. That’s not far from its 52-week low of 0.501 hit at the start of the pandemic in mid-March.