Looking Beyond Market Stabilization to the Future Path of Monetary Policy

Coming into the April meeting of the Federal Open Market Committee (FOMC), the policy rate was already at the effective lower bound, and the Federal Reserve had already introduced a range of lending facilities spanning asset markets, all in an effort to mitigate the economic damage of COVID-19. As a result, the market expected little in the way of “new” programs to ease credit conditions.

Still, over the coming months, we think the Fed’s focus will shift from one of crisis management to one of keeping financial conditions easy. Indeed, Fed Chair Jerome Powell hinted at this during the press conference Wednesday, saying that while the Fed’s asset purchases support market functioning, they also “foster more accommodative financial conditions.” As its objective shifts – and as early as June – we think the Fed will provide additional, more tangible, guidance on the path of large-scale asset purchases, and on interest rates.

Since mid-March, the Fed’s balance sheet has swelled with an unprecedented pace of purchases of U.S. Treasuries and agency mortgage-backed securities (MBS). However, as markets pulled away from the brink of collapse, the Fed started to dial back the weekly pace of purchases in early April. Over the next few weeks, we think the Fed will likely continue to taper toward a “steady state” level, which it will then maintain at least through the fourth quarter of this year, by our estimates.

Eventually, as more information is gained on the depth of the recession and the extent of the recovery after the economy reopens, the Fed will also likely strengthen its forward guidance for the path of interest rates. The economic rebound is likely to be slow even as the economy reopens, and it will likely be some time before the U.S. economy reaches full employment and 2% core PCE inflation (the Fed’s inflation target, measured by personal consumption expenditures). And by linking guidance to inflationary outcomes, targeting an inflation overshoot, and even perhaps announcing a formal yield curve target two to three years out, the Fed could help the economy continue to benefit, as appropriate, from easy monetary conditions.

Background: Fed balance sheet rationale and impact

After a sudden increase in market volatility and risk aversion in mid-March contributed to extreme price dislocations in Treasury and MBS markets, the Fed began purchasing these securities with the goal of restoring smooth functioning of markets central to the flow of credit to households and businesses. By stabilizing the low-risk “core” of the asset market, the Fed hoped to foster efficient and effective transmission of its monetary policy across all markets.

In the past few weeks, market liquidity has improved from the massive disruption in March, but has not returned to normal. Still, the Fed isn’t expecting normal anytime soon, and was comfortable enough with the market’s progress to begin dialing back its pace of purchases in early April. “Supporting smooth market functioning does not mean restoring every aspect of market functioning to its level before the coronavirus crisis,” said Lorie Logan, manager of the Fed’s System Open Market Account (SOMA), in a 14 April speech. She added, “Nor does supporting smooth market functioning mean eliminating all volatility.”