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FOMC Update: What, Me Worry?

The Federal Reserve concluded its June meeting, and the results were more dovish than anticipated as 10-year US Treasury yields retreated toward their all-time lows. That the Fed could even appear more dovish after its recent historic liquidity interventions may seem surprising, especially since some of those polices seem to be working (or at least seem not to be doing major near-term harm). Equity markets have erased most corona crisis losses, the latest employment data are shockingly positive and consumers are rushing back to stores given the opportunity. Financial markets are stable, and valuations are rising. The real economy is mending. Everything is looking up! So why is the Fed so glum?

It was only a year ago that the FOMC was discussing ways to shift attention away from its quarterly Summary of Economic Projections—aka, the dot plot. These summary projections of growth and the likely path of the federal funds rate are meant to be inputs to the FOMC’s meetings: Each participant submits forecasts ahead of time, and these forecasts are compiled by Fed staff and used to frame conversations in the committee. Naturally, the market interprets them as the Fed’s definitive guidance—less of a collection of forecasts and more of a policy target. At the emergency meetings in March—peak corona crisis—the FOMC suspended the dot plot. Any attempts to forecast economic variables in that environment would undoubtedly have been futile. And perhaps the markets were better for not having the extra information (after all, there was a time when markets and investors operated without the dot plot at all). But now the dot plot is back, and the summary of forecasts is for rock-bottom rates until 2022. Contrast that to where the Fed was in December, and you’ll see why markets took the dovish news poorly (Exhibit 1).

Exhibit 1: Implied Fed Funds Target Rate

Source: Bloomberg

 

The Fed remains concerned about uncertainty and longer-term structural issues—i.e., still-high unemployment along with outright deflation. In the prior expansion (RIP), unemployment rates plumbed historical lows, fulfilling one of the Fed’s statutory mandates. When it comes to stable prices, another prime mandate, it wasn’t so successful. Despite the low unemployment rate, inflation never reached the 2% target on a “symmetric, sustained basis.” Chairman Powell suggested the Fed needs to be humble about how much control it has over inflation and focus on what needle it (allegedly) can move: jobs.

Of course, the Fed itself isn’t re-hiring millions of people. Nor is the Fed able to backstop incomes directly. New tools like the Mainstreet Lending Program and corporate bond purchase program will support business directly. The alphabet soup of new lending facilities augments the Fed’s more traditional tools, and the money supply has already surged by a staggering 23% over the year to June 1 (Exhibit 2).

Exhibit 2: M2 Money Stock

Source: Board of Governors of the Federal Reserve System (US), M2 Money Stock [M2], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/M2, June 16, 2020.

 

M2 comprises cash in circulation, bank deposits, CDs and money market fund assets. Tack on to this a jump in the personal savings rate (thanks in no small part to robust fiscal transfers) and we’ve got a massive amount of liquidity in the system. Perhaps this dry powder may lead to exploding prices over the longer term, helping the Fed succeed with its inflation-targeting where it previously failed. But for the moment, inflation is muted, and economic transactions are historically depressed, as we can see from the velocity of M2, which illustrates the amount of economic activity (i.e., GDP) as a share of the money supply (Exhibit 3).  

Exhibit 3: Velocity of M2 Money Stock

Source: Federal Reserve Bank of St. Louis, Velocity of M2 Money Stock [M2V], seasonally adjusted (SA) retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/M2V, June 16, 2020.

 

That the monetary policy response to this crisis has been unprecedented reflects the Fed’s deep concerns about potential cracks in the real economy. After all, the FOMC doesn’t foresee economic conditions improving sufficiently at any point over the next two years to anticipate raising rates. In fact, it is “not even thinking about, thinking about raising rates.” So where is all this liquidity if it’s not flowing into real economic transactions? As banks’ reserve balances at the Fed have surged and money market fund assets are booming, it looks like the liquidity has found a home in the financial system’s plumbing. Perhaps being flush with liquidity makes financial assets ripe for higher prices when sentiment shifts. Perhaps the liquidity eventually goes to work in the real economy—whether through rising wages’ or growing demand driving inflation. Perhaps both (or neither) come true. For the time being it sits idle, earning practically invisible yields, weighing on the Fed’s collective mind.