The December Federal Open Market Committee statement didn’t break three legs to a duck (pardon my French). The only innovation came from the Fed introducing outcome-based qualitative forward guidance — a fancy term to suggest the Fed will maintain its current asset purchases until “substantial progress” had been made toward the Fed maximum employment and inflation objectives.
But, while Federal Reserve Chairman Jerome Powell beckoned “strong” forward guidance and “powerful” policy support, he also inadvertently pointed to the Fed’s near-term policy limitations. The Fed is not out of policy ammunition, but the policy ammunition it carries is inadequate to deal with any further weakening of economic activity.
First, Powell stressed that monetary policy acts with “long and variable lags.” This implies that while the Fed may be concerned about the near-term deterioration in economic activity, it doesn’t believe monetary policy can do much to alleviate these strains.
This intrinsic limitation forced Powell to provide a nuanced economic perspective. While he acknowledged that the economic situation was rapidly deteriorating, and that millions of Americans would struggle to cross the economic chasm left by the pandemic, he made a concerted effort to note the economy should be performing strongly in the second half of 2021 as some tranches of the population would feel increasingly comfortable to spend once the vaccine was widely distributed.
In line with the gradually shifting fiscal paradigm, the Fed chair noted that rising debt should not be a concern in a low interest rate environment where the real burden of debt – interest payments – is historically low.
A reality that will likely last for the foreseeable future, as the Fed’s new flexible average inflation targeting framework will favor an accommodative policy stance over the next few years. In fact, the Fed’s stance could paradoxically become increasingly accommodative if it maintains the policy rate at the effective lower bound for the next couple of years. As inflation firms, the inflation-adjusted policy rate could fall further below the neutral rate, thereby providing extra medium-term stimulus to the economy.
The second Fed limitation is that while the Fed’s quantitative easing (QE) program is increasingly viewed as a tool to support economic activity, rather than support market functioning, the current low rate environment limits any future marginal stimulus effect from adjustments to its QE program.
This forced Powell to repeatedly stress that the current policy stance was appropriate considering the Fed’s economic outlook. Indeed, while policymakers may be open to ramping up asset purchases, or adjusting their composition, to tamp down on potential rises in long-term interest rates, it appears much of the Fed policy support now rests on hope.
Hope that Congress provides enough fiscal stimulus, hope that the near-term outlook is as optimistic as the Fed expects and hope that financial market stability remains a constant.
Gregory Daco is the chief U.S. economist at Oxford Economics.