The Federal Open Market Committee retained its accommodative policy stance on Wednesday, keeping short-term rates at the zero bound to provide liquidity for commercial activity. The FOMC said it would maintain its monthly purchases of securities to pressure long-term interest rates lower, facilitating investment.
The FOMC’s decisions were an affirmation of its dovish stance on monetary policy as it continued to emphasize that the economy is some time away from achieving maximum sustainable employment.
The following charts provide some background for those policies and the impact on interest rates.
The Fed has mandates on inflation and employment …
The Federal Reserve’s mandate is to maximize output while maintaining price stability. Note that price stability does not mean zero inflation. Rather, most central banks have determined that a healthy economy requires inflation centered on a 2% yearly rate.
The FOMC expects inflation rates above 2% this year, but this is because of comparisons to the low levels of the pandemic last year and transitory increases resulting from pandemic-related shortages. Because inflation had been running at less than 2% for several years, the committee said it would “aim to achieve inflation moderately above 2% for some time so that inflation averages 2% over time and longer‑term inflation expectations remain well anchored at 2%.”
Unemployment is expected to shrink toward 3.5% over the next two years and then revert to a 4% equilibrium rate, according to FOMC projections as of its June announcement.
So it keeps a close eye on price levels …
The FOMC looks at the Personal Consumption Expenditures Index of inflation rather than the Consumer Price Index. Nevertheless, the CPI is what captures the headlines and public perceptions of price increases.
The CPI would be expected to fall along with demand during economic downturns, and to rise when demand increases as economic activity resumes during the recovery. The 2020 recession is unusual—a supply crisis that turned into a demand crisis and then back to a supply crisis during the recovery. We consider those shortages to be transitory and unavoidable, and eventually corrected as production is resumed and supply chain difficulties are worked out of the system.
Which is why it continues to keep rates near zero …
A lesson learned from previous downturns is that the monetary and fiscal policy response must be quick and then consistent for economic recovery to be sustainable. In the absence of persistent inflation, we expect the FOMC to maintain the federal funds rate at the zero bound until full employment is reached for all stratifications of society. Much of that will depend on the response of Congress and the Biden administration.
The drawn-out recovery from the 2008-09 financial crisis is the most recent example, with the federal funds rate kept at the zero bound from 2008 to 2015 and not allowed to move higher until the commodity-price collapse began working its way out of the system.
… and purchase securities to encourage investment
Investment is necessary to sustain economic growth. This is why we expect the FOMC to continue pressuring long-term interest rates lower by maintaining the Fed’s holdings of Treasury securities and purchases as needed. There are calls for ending the Fed’s purchases of mortgage-backed securities to quell price increases in the housing market, but that should probably be coordinated with a fiscal policy response.
Fed purchases are not done in a vacuum. Rather, other factors like the pace of COVID-19 vaccinations and the spread of the delta variant are having an effect on the market’s perceptions of potential economic growth and the appropriate level of long-term interest rates.
It’s all part of an effort to keep long-term rates down …
Long-term rates contain expectations for short-term rates and the risks of inflation or deflation. The gradual decline in long-term interest rates was possible only when inflation was squeezed out the economy. And then short-term rates were sent to a bare minimum in response to the financial collapse in 2008-09 and again when the pandemic caused a global economic shutdown.
The Fed’s clear guidance that short-term rates would remain extremely low for as long it took to revive the economy has been instrumental in keeping long-term rates at these low levels.
Because long-term rates are also determined by the perceptions of growth and the demand for investment in that growth, you would expect long-term rates to closely follow the perceptions of economic growth found in manufacturing orders.
Because of perceptions of American institutions, you would expect the safe-haven demand for U.S. securities to have an impact on the price of Treasury securities.
… and encourage businesses to invest in the new economy
We expect real (inflation-adjusted) yields to remain negative. The secular decline in real interest rates toward zero since the 1980s suggests both a realignment of expectations after the postwar industrialization of the American economy, and the opportunity for a re-imagination of their role within what is now a global economy.
Investments made now will be paid back in deflated-dollar terms—a once-in-a-lifetime opportunity to kick-start an advanced-manufacturing economy populated by an educated, healthy and skillful workforce.
For more information on how the coronavirus pandemic is affecting midsize businesses, please visit the RSM Coronavirus Resource Center.
