Fed comfortable with monetary policy stance, out of the spotlight for now

The Fed left monetary policy unchanged at its January 26-27 FOMC meeting. It maintained its target range for the federal funds rate at 0-0.25% and reiterated that it will continue its large-scale asset purchases (LSAPs) at least at the current pace – $80 billion per month in Treasury securities and $40 billion per month in mortgage-backed securities (MBS) – until substantial further progress has been made toward its maximum employment and price stability goals. With real GDP still below its Q4 2019 level, a labor market that is a long way from normal, and the Fed’s preferred measures of inflation still far below its 2% target, the Fed is comfortable with its highly accommodative monetary policy stance.

Minor changes to the Fed’s Policy Statement. The Fed tweaked its statement to acknowledge the slowdown in activity stemming from the intensification of the pandemic in December, noting that “the pace of the recovery in economic activity and employment has moderated in recent months, with weakness concentrated in the sectors most adversely affected by the pandemic.” We view this slowdown in activity as temporary and expect a reacceleration in economic and job growth in the coming months as the pandemic ebbs, vaccines become more widely distributed, and conditions begin to normalize. Indeed, estimates of U.S. mobility trends have already started to increase, following months of declines, as the reported number of new COVID-19 cases and hospitalizations have fallen markedly (Real-time insights, economic and financial pulse, January 25, 2021).

The Fed made no changes to the forward guidance for its LSAPs. Its massive $120 billion monthly purchases of Treasury securities and MBS have lifted the size of its balance sheet to a record $7.4 trillion. The minutes to this meeting (scheduled for release in three weeks) will reveal any further discussion of plans for its LSAPs. We believe the Fed will continue its asset purchases at this current $120 billion monthly pace in the medium-term and consider tapering purchases only after real GDP has regained its pre-pandemic level.

The outlook for monetary policy. The Fed will maintain its ultra-easy monetary policy as long as labor markets are recovering and inflation remains moderate. Its new strategy, which focuses on shortfalls in employment and maximum inclusive employment, makes it decidedly dovish. Fed Chair Powell reiterated in his press conference that he believes an increase in inflation from the release of pent-up demand when conditions normalize would likely be transitory. But what if actual inflation rises significantly above 2% for a sustained period, putting the Fed’s above-2% “make up strategy” for inflation to the test? What if survey- and market-based measures of inflation expectations spike, pushing up bond yields? Interestingly, in recent days, closely watched market-based measures of inflation expectations have declined and the 10yr UST yield has fallen by 10bp to 1.01%, despite the high likelihood of additional COVID-19 relief legislation.

The Fed is comfortable with its current monetary policy stance. Fiscal policy has taken over the spotlight, which the Fed has willingly yielded. Let’s see how long this lasts.

Roiana Reid, roiana.reid@berenberg-us.com

Member FINRA & SIPC
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