Much is riding on the Federal Open Market Committee policy rate meeting next week, given recent changes in the economic landscape.
Rising growth expectations, increasing interest rates, modestly higher inflation expectations and the recent challenge to the Federal Reserve’s flexible average inflation targeting regime by the fixed income market have combined to add new dynamics to the Fed’s deliberations.
While we expect no change in the Fed’s policy rate (range between 0-0.25%), its pace of asset purchases ($120 billion per month) or its forward guidance (no rate hike through 2023), there will be an upward revision to the Fed’s growth forecast, a reduction in its unemployment estimate and perhaps a mild increase in its 2021-22 inflation forecast.
Just as important, because of the echo of policies enacted a year ago to address the pandemic, the Fed will most likely need to address its non-monetary policy tools to avoid a general tightening of lending for small and medium-size enterprises.
We expect the Fed to make some technical adjustments to ensure that lending for small and medium-size enterprises does not tighten.
For this reason, we expect the Fed to lift the interest it pays on overnight reserves (IOER) by five basis points, from 10 to 15, and increase the interest it pays on overnight reverse repurchases (ON RRP) by five basis points, from zero to five. We also expect the Fed to consider extending its temporary exemption of bank reserves and Treasury securities from leverage ratio calculations that were granted last March as the pandemic took hold.
While these non-monetary policy actions will be a close call, we think that they are in the interest of the Federal Reserve and the U.S. economy to ensure that lending for small and medium-size enterprises does not tighten at this nascent stage of the recovery.
While we understand that this will cause consternation in some corners of the political authority, the $800 billion or so that is going to move from the Treasury’s general account to excess reserves on balance at the Fed through the banking system will exert downward pressure on rates. This pressure would almost certainly cause banks to pull back on lending because of binding leverage ratio requirements.
That, of course, would be at odds with the $120 billion in asset purchases by the Fed intended to dampen rates at the long end of the curve, bolster lending and boost economic activity.
Communications
While all Fed meetings are followed by a news conference with Chairman Jerome Powell, the March 17 event will be a bit more important than others, following the backup in the 10-year Treasury yield toward 1.6% that took place during Powell’s discussion of monetary policy and financial markets on March 3.
We anticipate sharp questions on the challenge to the Fed’s inflation-targeting policy by the fixed income community in light of the robust growth forecasts by economists and the Fed. These forecasts have been accompanied by the formation of inflation expectations, the technical challenges at the front end of the curve and Powell’s view on the shape of the post-pandemic economy.
This figures to be the main event because of Powell’s inclusion of the word “patient” in his statement last week, which the fixed income trading community interpreted as a tolerance of higher yields.
While Powell went out of his way to make the case that he did not expect the formation of inflation expectations to change as the economy recovers from the pandemic, that did not stop the inflation worriers from prattling on about risks to the outlook.
The Fed’s preferred measurement of future inflation, the five-year, five-year forward inflation expectation rate, recently stood at 2.3%, which is not exactly what one would call a material risk to the economic outlook. This reading follows a long period where the central bank’s policy variable, the core personal consumption expenditure, has averaged 1.6% over the past five and 10 years.
FOMC statement
We expect that the FOMC statement will be modestly updated to reflect both the improving economic situation and expected upgrades in the Summary of Economic Projections to be published simultaneously on March 17.
If there are changes to the statement, this will almost certainly occur in the economic outlook portion of the communique in the third paragraph to point toward a materially quicker pace of growth.
Second, Powell’s recent use of the word patient may be integrated into the policy outlook paragraph to reinforce the Fed’s intent on permitting inflation to run above the 2% target to get back to full employment and to underscore its commitment to its FAIT policy.
But investors should anticipate the committee to signal that it has no intention of increasing the policy rate or removing policy accommodation in the near term. In particular, the statement will reaffirm its previous position that the central bank “expects to maintain an accommodative stance of monetary policy” until “maximum employment” is achieved and inflation runs “moderately above 2% for some time.”
Summary of economic projections
Economic data has improved of late and the Fed has no doubt taken into account the nearly $4 trillion in firepower sitting in household cash accounts through January, a number that is almost certain to grow given the likely passage of the Biden administration’s $1.9 trillion American Rescue Plan.
We expect a material upgrade to the Fed’s growth forecast for gross domestic product in the range of the 5.5% consensus for this year (RSM’s forecast is at 7.2%, up from 6.1% previously) and an improvement on the unemployment forecast to 4.8% from 5% in December.
The closest call of the Summary of Economic Projections will be around the inflation forecast, which could see an increase in the Fed’s estimate to 2.3% this year and 2.2% next year, which would bring it in line with the consensus forecast.
The dot plot is where things will likely get a bit more interesting, given that the market has priced in two full rate hikes in 2023 in contrast with the Fed’s forecast of no rate hikes through 2023. There will no doubt be a couple of dots that imply a possible lift-off on rate hikes sooner than suggested by the December forecast, but not enough to alter that outlook.
Here the market may choose to interpret this as the Fed’s signaling to investors that it is putting its money where its mouth is when it comes to policy. This may be more important than any of the words Powell uses to convey his outlook at the news conference.
Technical adjustments at the front end of the curve
We already noted that the Fed will need to make technical adjustments to prevent rates from moving negative at the front end of the curve and avoid a tightening of lending conditions for small and middle-market firms.
As the Treasury reduces cash held at the Fed in its general account (TGA) that cash, which is likely to be reduced to near $800 billion to $1 trillion in the coming weeks, will be recycled through the banking system into excess reserves, which already stand at $3.6 trillion.
The increase in excess reserves, which could be as much as $1 trillion, would cause rates at the front end of the curve to go negative, which would create enormous headaches in domestic money market funds and require an increase in the interest it pays on overnight reserves and interest it pays on overnight reverse repurchases.
While we have thought for some time that it makes sense for the Fed to construct a standing repo facility, that is likely not in the cards. So the Fed should be expected to act swiftly and prudently to avoid any disruption to rates at the front end of the curve and a tightening of lending into the real economy.
Just as important, that excess cash will affect the calculation of supplementary leverage ratios in the banking system in general, and as it applies to the large banks in particular.
In addition, we would not be surprised if the Fed is considering implementing Operation Twist III, in which it would sell short-dated securities at the front end of the curve, pushing up rates at the front end, and buying long-dated securities that would twist down rates at the end of the Treasury curve. All this would be done without changing the level of Fed holdings of fixed-income securities..
While we do not anticipate such action at the March 16-17 meeting, we would not be surprised to observe such a discussion when we get a chance to look at the FOMC minutes during the March-April inter-meeting period.
For more information on how the coronavirus pandemic is affecting midsize businesses, please visit the RSM Coronavirus Resource Center.
