The Federal Reserve reiterated its intention to “act as appropriate to support the economy” at the conclusion of this week’s policy meeting while worrying that resurgence of the virus threatens to derail the recovery. Federal Reserve Chair Jerome Powell emphasized the importance of fiscal policy in supporting the recovery, a not-thinly veiled hint that Congress (or, more specifically, Senate Republicans) need to get their act together. No new policy measures were announced although Powell did hint that the policy review would be complete by September. Overall, a dovish message. The Fed intends to maintain accommodative financial conditions for years.

The FOMC statement was little changed from June, with the most notable addition being:

The path of the economy will depend significantly on the course of the virus.

This is not exactly news for most of us, but the Fed felt it important to emphasize that there is no tradeoff between the economy and public health. Until the virus comes under control, the economy can’t full recovery. The Fed is especially concerned that a resurgent virus already worsens the outlook. From Powell’s opening statement:

Indeed, we have seen some signs in recent weeks that the increase in virus cases and the renewed measures to control it are starting to weigh on economic activity.

Powell reviewed the Fed’s actions to support the economy and highlighted the importance of fiscal policy in minimizing the extent to the recession:

Elected officials have the power to tax and spend and to make decisions about where we, as a society, should direct our collective resources. The fiscal policy actions that have been taken thus far have made a critical difference to families, businesses, and communities across the country. Even so, the current economic downturn is the most severe in our lifetimes. It will take a while to get back to the levels of economic activity and employment that prevailed at the beginning of this year, and it will take continued support from both monetary and fiscal policy to achieve that.

Powell commented heavily on fiscal policy, including praising the steps taken to date while making clear that the job is not done. It is hard to interpret Powell’s position as anything less than a rebuke to Senate Republicans who have positioned the U.S. economy to fall over a fiscal cliff despite months of warning. Powell could not be happy that he has to be the adult in the room; the Fed would prefer to stay out of fiscal policy. My suspicion is that he doesn’t think staying quiet is an option. Why? Because buried under Powell’s plead for more fiscal support was the implication that the Fed would be unable to compensate for a fiscal retreat. To be sure, in response to a reporter’s question Powell said the Fed has more tools available. Those tools, however, would not be sufficient to compensate for the fiscal cliff that lies ahead.

Powell said that meeting participants discussed the policy and strategy review and that they will “wrap up our deliberations in the near future.” That to me sounds like September. He did not give any hints as to the outcome of that process. He played his cards a little closer to his vest than I anticipated. We will need to wait until the Fed releases the meeting minutes to learn more about the discussion.

The overall message was dovish: Powell indicated that disinflationary pressures were likely to dominate for the foreseeable future, that the recovery would not happen quickly and hence unemployment would remain persistently high, and that people really need to stop asking him when they will consider raising rates. That question is so far from his mind that he can’t even begin to answer it.

Bottom Line: The Fed remains committed to accommodative policy. I expect that the Fed will conclude its policy review by September and then they will be free to take additional action. The three most obvious future actions are enhanced forward guidance, shifting asset purchases to the long-end of the yield curve, and yield curve control at the short end. Those would most likely occur prior to an expansion in the pace of asset purchases.

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It will be a busy week for data. The Fed will continue to paint a dovish picture of the economy. I am watching four other stories right now: Delayed fiscal policy, rising inflation expectations, a weaker dollar, and a potential leveling off of Covid-19 infections.

Bloomberg Opinion

My Bloomberg column last week:

The Federal Reserve has come around to the conclusion that inflation isn’t going to be a problem. So now it’s time to start wondering if inflation is going to be a problem. The Fed has a tendency to fight the last battle, which could lead policy makers to miss what may be the “Great Inflation” era.

Continued here.

Key Data

The U.S. housing market remains remarkably resilient. New single-family home sales rebounded to an annual rate of 776k, their highest level since 2007. Existing home sales continue to recover lost ground; I anticipated they will come closer to full recovery in the July numbers. Median sales price also rose and is 3.5% higher than a year ago.

The strength of housing appears inconsistent with a recession, but the pandemic comes at a time of structural strength for the sector. Aging millennials provide demand for housing after a long period of low levels of construction. Low mortgage rates create further incentive to buy. And those boomers you thought were ready to leave their homes and open up some supply? That’s going to be delayed again. Seriously, if you are 60 years old and watching the news, you probably think that retirement communities and nursing homes are basically death traps. To me, that argues for people working harder to stay in their own homes for longer.

Initial unemployment claims edged higher; continuing claims continue to fall slowly. Slower activity and renewed firm closures in the worst-hit pandemic regions will likely put some upward pressure on claims in the coming weeks. The labor market simply will not heal easily until the pandemic is contained.

The IHS Markit flash report for July improved to a six-month high but also indicated headwinds to growth from rising Covid-19 cases. The Eurozone version posted the strongest numbers in two years. Almost as if a credible response to the pandemic was important for the economy.

Fedspeak

Blackout week ahead of this week’s FOMC meeting, so thankfully we could all take a break.

Upcoming Data

Busy week ahead as the data flow picks back up. Monday we get durable goods orders with core orders excluding defense and air are expected to be up 2.3% in June. These numbers have held up better than expected given the depth of the downturn; stronger investment now would help mitigate some of the negative long-run impacts from this recession. Conference Board consumer confidence comes on Tuesday; it is expected that virus-pessimism drags down the number to 94.5 from 98.1 in June.

Wednesday is FOMC day plus press conference; no policy changes expected but the overall event will have a dovish feel. Also Wednesday is pending home sales for June. Watch for more signs of a V-shaped recovery in this sector.

Thursday will be exciting! Be ready for a historic collapse in the GDP numbers over the second quarter, expected to be down 34% on an annualized basis (block anyone who says output dropped by a third). We are all prepared for the worst so I am a little cautious that there is room for an upside surprise. Also on Thursday we get the usual initial claims report.

Friday brings the household spending and income numbers for June although we should have a pretty good idea of the outcome from the GDP report the previous day. Pay attention to the core-PCE numbers as all of our dovish Fed bets hinge on that staying weak. Likewise, we get the University of Michigan sentiment numbers for July. I am watching the inflation expectations numbers in particular.

Discussion

I discussed the Fed last week, and nothing much there has changed. The Fed is stuck between the emergency actions of this past spring and the next steps to bolster the recovery that will come later this year. The most likely outcome for this week is no policy change but a dovish tone to the statement and the press conference.

Aside from the Fed, there are four stories I am watching right now. The first is fiscal policy. The enhanced unemployment benefits – a critical lifeline for the economy – are coming to an end. Republicans in the Senate are rushing to cobble together their own package two months after the House Democrats passed theirs. I find this delay hard to believe given that with each passing day the Republicans look to be suffering more in the polls and this would have been an easy way to get ahead of at least the economic concerns. Instead, the Republicans look like they were hoping that if they didn’t do anything, the virus would just disappear on its own. In the very near-term, the delay could weigh on spending and consumer and investment sentiment. That said, the delay may have shifted the bargaining strength to the House Democrats; if so, the ultimate package will be larger.

A second area is inflation and inflation expectations. Interest rates on TIPS are down as investors look to secure protection from inflation. Or maybe not. Roberto Perli from Cornerstone Macroeconomics argues that this is not the case:

(4/4) As liquidity normalizes, the TIPS liquidity premium drops. This pushes TIPS yields down and spot breakevens up. There is no inflation story, just a liquidity story. pic.twitter.com/u3ocFeKDnH

— Roberto Perli (@R_Perli) July 24, 2020

The TIPS market is known for being less liquid; you have to expect you might have a hard time selling a position and thus would need to protection in the form of a lower price/higher rate. If liquidity in the market is now improving and you can more easily find a buyer, prices should rise and rates fall, but this is not about inflation expectations.

I wonder if we can so clearly separate liquidity conditions from inflation expectations. If I think that other investors are worried about inflation, then I might reasonably conclude that market conditions would improve. Likewise, if I think the tail risks of deflation have lessened, I might think there were more potential buyers. I have in my head the idea that a market for inflation protection would be more liquid if participants were actually worried about inflation (or at least no longer worried about deflation). Also, is you think the Fed will via financial repression hold nominal rates flat, you would think there would be a bias towards TIPS.

Regardless, narratives matter and the story around inflation is one worth watching. I have said before that inflation is not likely a problem given the size of the negative demand shock and, consistent with that observation, the rise of inflation expectations doesn’t yet approach a level that would be concerning from a policy perspective. But there is also room to rise between here and where there might be some policy implications. So I am just keeping an eye on these next few inflation numbers and how they might feed into this story.

A third and related story is the dollar, which looks to be vulnerable. As noted earlier, the Eurozone looks to be recovering from the Covid-19 shock more rapidly than the U.S. This coupled with a Fed looking to ease further is dollar negative, at least for now. And, as you know, once a narrative takes hold in currency markets, it can be sticky and trigger a big move. Which interestingly would put upward pressure on core inflation and thus create some interesting dynamics on that issue.

The final story is the possibility that Covid-19 infections in the U.S. are leveling off. This thread from Jens Nordvig of exante data is important:

Most likely, the US will now stay in an odd greyzone, with more stable, but still very elevated case growth into August. And each state will have to worry about importing cases from others states with bigger outbreaks (as domestic travel bans are unrealistic)

— Jens Nordvig (@jnordvig) July 24, 2020

Stabilization of Covid-19 cases would be good in that it might short-circuit more pessimistic scenarios of further shut-downs but bad in comparison to the Eurozone. That too could be on net dollar negative.

Bottom Line: Housing is a stand out sector, but can’t carry the U.S. economy all by itself. The inability of the U.S. to manage the pandemic leaves the economy struggling in absolute terms and relative to its peers. Delays in the next fiscal support picture negative in the very near term but might lead to a big package. Fed will stay dovish. 

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The pandemic will continue to weigh on the economy but ongoing fiscal support matched by Fed easing will

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help ease the pain and support markets.

Bloomberg Opinion

My Bloomberg column last week:

For the Federal Reserve, this time really is different. Having learned a hard lesson in the last recovery — don’t tighten monetary policy too early — the central bank is leaning in the opposite direction. In practice, that means the Fed will not just emphasize actual inflation over forecasted inflation, but will also attempt to push the inflate rate above its 2% target. It’s a whole new ballgame.

Continued here.

Key Data

June retail sales were above expectations and May numbers revised higher. Core sales (excluding gas, autos, food services, and building materials) are solidly above the pre-pandemic trend even though unemployment is in double digits. To me, this is pretty clear evidence that fiscal policy works. Put money in the hands of people who can and will spend it, and they spend it. Looking forward though, renewed shutdowns in states such as California and the general loss of confidence as Covid-19 numbers track higher calls into question the ability of the consumer to sustain this momentum going into the back half of the year. This likely accounts for the softening from 78.1 to 73.2 in the preliminary July release of University of Michigan consumer sentiment. Fiscal policy is crucial here; Congress needs to deliver a package that includes extending enhanced unemployment benefits.

Industrial production jumped 5.4% in June as the lockdowns eased, but remains 10.8% below last year’s levels. The nation’s car manufacturers are ramping up production to meet a rebound in demand. Remember though the initial gains will come most easily. Future gains will be slower.

One sector that looks to be having a real V-shaped recovery is housing. Housing starts continued to regain lost ground in June and homebuilder confidence in July to almost its pre-pandemic levels. Unlike the last two recessions, we didn’t head into this downturn with a substantial over-investment in any one sector of the economy such that it was impacting overall activity. If anything, the opposite was the case this time with housing still recovering from lost ground in the aftermath of the last recession while experiencing demographic-driven demand. Housing will provide some much-needed support for this recovery.

The story remains the same as far as initial unemployment claims are concerned. Progress has basically stopped with claims flatlining. Too many firms are realizing that they can’t either stay afloat or retain all their employees given the protracted period of time until the pandemic eases and life resumes to something approaching normal. The case for retaining enhanced unemployment benefits and a new round of PPP remains strong.

Consumer price inflation came in a bit above expectations; see my comments here.

Overall, the data continues to deliver something for everyone. There is enough bounce in the data to see the way forward, there is enough weakness in the data to justify pessimism about the sustainability of that path forward, and there is evidence that fiscal policy works and needs to be sustained.

Fedspeak

Chicago Federal Reserve President Charles Evans came out in support of allowing inflation to drift above 2% before tightening policy. Via Ann Saphir at Reuters:

“I am hard pressed to think of reasons why we would need to move away from accommodative monetary policy unless inflation was well above 2% for an extended period of time, and the economy was just very different from what we are seeing right now,” he said in a virtual event held by the Global Interdependence Center. “That doesn’t seem to be very likely.”

He follows comments by Federal Reserve Governor Lael Brainard arguing for holding policy steady until inflation reaches 2% in support of overshooting the inflation target:

With the policy rate constrained by the effective lower bound, forward guidance constitutes a vital way to provide the necessary accommodation. For instance, research suggests that refraining from liftoff until inflation reaches 2 percent could lead to some modest temporary overshooting, which would help offset the previous underperformance.

See my comments here for more on Brainard.

While the majority of the Fed is moving toward enhanced forward guidance, some are resisting. Via Greg Robb at MarketWatch:

In a separate interview with Yahoo Finance, New York Fed President John Williams suggested new forward guidance wasn’t needed in the short-term.

Right now, the Fed’s guidance language “is serving us well,” Williams said.

“So we do have some time to think about how we should evolve that guidance as we go forward,” he added.

Williams tends to be a lagging indicator on these sorts of things. Williams also commented on the lack of use of the Fed’s emergency lending facilities, via Reuters:

“This is in fact a measure of success — the existence of the facilities, even in a backstop role, has helped boost confidence to the point where borrowers are able to access credit from the private market at affordable rates,” he said.

The Financial Times also reports on the limited use of the Fed’s programs and notes that it is reducing investor expectations for the growth of the balance sheet. The much-anticipated Main Street Lending program has been a dud. Personally, this is as I expected. This isn’t the Fed’s job and they don’t have any experience in it. Nick Timiraos and Kate Davidson at the Wall Street Journal write that U.S. Treasury officials also worked to limit the attractiveness of the program:

Fed officials generally favored easier terms that would increase the risk of the government losing money, while Treasury officials preferred a more conservative approach, people familiar with the process said.

While Treasury didn’t make the Fed’s job any easier, I think there is a more fundamental problem. Firms with operations that can survive the pandemic are probably both solvent and do not face a liquidity constraint from tight credit. They are already getting the financing they need. Firms that cannot survive the pandemic are insolvent and if you want to sustain them, they need a grant (like what U.S. Treasury Secretary is arguing for PPP loans less than $150,000; see the Wall Street Journal), not a loan, even a long-term, low-interest loan. It’s still a weight on their future profitability and enhances the risk of business failure after the pandemic is over. I suspect the space in-between, firms that both can’t get financing now but are fundamentally solvent and can afford to pay back the loan after the pandemic, is fairly small. Federal Reserve. Chair Jerome Powell though thinks I could be wrong. Via Reuters:

Fed Chair Jerome Powell has said he expects the Main Street Lending Program to come in handy in the fall, when more companies may be financially stressed enough to need to tap it.

Time will tell.

Upcoming Data

Only a handful of major data releases this week. Tuesday we have existing home sales, expected to be 4.86 million for June compared to 3.91 million the previous month. More housing data will come Friday with new home sales for June, 700k expected versus 676k in May. See comments on housing above; this sector has shown remarkable resiliency to date. Thursday we get the usual unemployment claims data. Market participants are looking for initial claims to remain flat at 1.3 million; obviously a substantially lower number would be a ray of sunshine on the bleak labor landscape but such an outcome seems unlikely.

Discussion

The Fed is moving past the emergency response phase of this recession and into the supporting/accelerating the recovery phase. They will continue to fiddle with the lending programs, but I suspect the take-up of those programs won’t accelerate greatly unless the Fed drops interest rate to zero and extends the repayment horizon to 10 or 20 years. I am thinking the Fed will lose interest in the programs sooner or later and adopt William’s position that the lack of use reflects sufficient credit availability. In other words, the Fed did its job saving the financial system; anything else is just a bonus.

It is fairly evident that the Fed is thinking about what comes next. I continue to anticipate the following themes:

1. Deflationary forces dominate the landscape, so there is no reason to think about raising interest rates.
2. No, really, we aren’t thinking about raising rates.
3. Because we know you probably won’t believe us as soon as the economy looks a little better, we are going to have to lock down your expectations with more aggressive forward guidance.
4. And, because we kind of screwed up in the last expansion, this time we are not going to pull back on accommodative policy until inflation is actually at 2% and we can be sure we are going to overshoot.
5. Overshooting though isn’t part of our policy set yet, but we have been reviewing our strategy and procedures (nudge, nudge, wink, wink).
6. If unemployment stays high, we are going to have to do something else, probably yield curve control but not everyone is on board with that yet.

The obvious implication is that interest rates will remain close to zero at the short and medium end of the curve and held down at the longer end. This is going to stress a lot of people out because “interest rates and stocks are telling different stories.” Seriously, like rates haven’t been falling since the mid-80’s while stocks rose? Rates are structurally low now. They don’t need to rise to confirm the gain in equities. Remember what happened in 2018 after the Fed got it into its head they it could raise rates to something closer to “normal.” They had to reverse course.

Another thing to watch for are claims that the Fed is pushing on a string with regards to inflation. I get that story. After all, the Fed didn’t get to 2% in the last cycle, why would we believe them now? And, well, you know, Japan. A couple of responses: During the last cycle, the Fed didn’t really have a strategy for getting to 2% on a sustained basis because they were trying to come in from below, particularly early in the cycle. In effect, the Fed sabotaged itself with excessively tight policy because they were trying to hit exactly 2% not an average of 2%. This was compounded by an adherence to a Phillips curve framework despite persistently low inflation. The Fed is trying to remedy both errors.

Also important is the Fed is sending a signal that they won’t automatically offset fiscal policy. They need to see actual not forecasted inflation. The Fed not getting in the way of expansionary fiscal policy should support inflation, assuming Congress keeps up a rapid pace of deficit spending.

Bottom Line: The virus is dictating the agenda. Until we can control Covid-19, the recovery overall will struggle even if some sectors like housing look promising. We have the fiscal capacity to ease the pain, and will probably continue to use it. The Fed is looking more toward the future and seeing an array of options to support and accelerate the recovery.

Consumer price inflation came in higher than expected in June. Headline prices rose 0.6% (expected 0.5%) on the back of a sharp 12.3% rise in gasoline prices but also a 0.6% gain in food costs. Still, even after excluding food and energy, core prices rose 0.2% (expected 0.1%). That said, one month does not make a trend. It is a challenge to expect strong inflationary pressures to emerge given the weak economic environment. The Fed should be free to maintain a very accommodative policy stance. Federal Reserve Governor Lael Brainard indicated the Fed is heading toward even easier policy and gave a strong signal that yield curve control was coming.

Core CPI snapped back to a 2.6% annualized pace in June as activity across the nation picked up:

Shelter inflation, typically a source of cyclical pressure, remained weak:

Outside of shelter, food, and energy, prices were firmer:

As I wrote yesterday, one upside inflation surprise isn’t very interesting. Given the general economic weakness and high levels of unemployment, the outlook screams “disinflation.” That’s the baseline expectation. Still, it is always worth thinking about a counter-intuitive position. To get to an inflationary outlook, I think you have to expect considerably longer support for incomes such as that in the first half of the year coupled with the negative supply shock delivered by the virus. Basically, a story in which we have finally delivered enough fiscal stimulus to generate some upward pressure on prices given that a nontrivial fraction of what we would normally be spending on has been shuttered or we are avoiding for safety concerns. Again, not my baseline, but I am always on the lookout for changing dynamics when we all finally agree to some conclusion. When and if inflation ever does become interesting again, I am confident that we will first spend 5 years denying that it is interesting.

Federal Reserve Governor Lael Brainard presented a rather sobering outlook for the U.S. economy anticipating that conditions will be sufficiently weak to generate years of below-target inflation. What does that mean for policy? She provides a roadmap:

Looking ahead, it will be important for monetary policy to pivot from stabilization to accommodation by supporting a full recovery in employment and returning inflation to its 2 percent objective on a sustained basis. As we move to the next phase of monetary policy, we will be guided not only by the exigencies of the COVID crisis, but also by our evolving understanding of the key longer-run features of the economy, so as to avoid the premature withdrawal of necessary support.

In other words, the Fed learned from the last expansion that they shouldn’t rush to tighten policy. Notably, the Fed need to avoid a deterioration of inflation expectations:

Because the long-run neutral rate of interest is quite low by historical standards, there is less room to cut the policy rate in order to cushion the economy from COVID and other shocks. The likelihood that the policy rate is at the lower bound more frequently risks eroding expected and actual inflation, which could further compress the room to cut nominal interest rates in a downward spiral.

Remember when we used to worry about inflation expectations becoming unanchored to the upside? Good times. Brainard argues that the Fed should ignore past estimates of the Phillips curve and make the pre-pandemic labor market the Fed’s policy objective:

With underlying inflation running below 2 percent for many years and COVID contributing to a further decline, it is important that monetary policy support inflation expectations that are consistent with inflation centered on 2 percent over time. And with inflation exhibiting low sensitivity to labor market tightness, policy should not preemptively withdraw support based on a historically steeper Phillips curve that is not currently in evidence. Instead, policy should seek to achieve employment outcomes with the kind of breadth and depth that were only achieved late in the previous recovery.

What tools does the Fed have to work with? Brainard goes first to the obvious two:

With the policy rate constrained by the effective lower bound, forward guidance constitutes a vital way to provide the necessary accommodation. For instance, research suggests that refraining from liftoff until inflation reaches 2 percent could lead to some modest temporary overshooting, which would help offset the previous underperformance. Balance sheet policies can help extend accommodation by more directly influencing the interest rates that are relevant for household and business borrowing and investment.

Note how she presents the inflation goal. The goals is to fall behind the curve and not act until actual inflation reaches two percent on a sustainable basis. That is very different than the Fed’s strategy of the last recovery. Then the Fed tightened on the basis of the inflation forecast. Now Brainard is looking to set policy on inflation outcomes. By doing that, policy lags will ensure the Fed creates above target inflation. She then gives a nod toward average inflation targeting by calling for a make-up strategy that offsets past inflation shortfalls.

Then she opens the door further for yield curve control:

Forward guidance and asset purchases were road-tested in the previous crisis, so there is a high degree of familiarity with their use. Given the downside risks to the outlook, there may come a time when it is helpful to reinforce the credibility of forward guidance and lessen the burden on the balance sheet with the addition of targets on the short-to-medium end of the yield curve.

The logic is essentially how I outlined the situation last week. The Fed will feel pressure to do more without expanding the balance sheet further. That leaves yield curve control as the next likely path forward. They have to talk it out first:

Given the lack of familiarity with front-end yield curve targets in the United States, such an approach would likely come into focus only after additional analysis and discussion.

Bottom Line: Don’t fret about the inflation number. It’s not yet a trend and telling a story of how it becomes a trend feels a bit forced even if interesting to think about. The Fed will soon be turning its attention on what more it can do. Eventually it will get to yield curve control.

Correction: In yesterday’s post, I incorrectly stated market expectations for today’s CPI report and instead used last month’s actual. Sorry for any confusion.

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The tricky part is weighing the negative of rising Covid-19 cases against likely positive influences on the

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economy. We might not get the rapid recovery we were hoping for months ago, but a recovery nonetheless.

Key Data

The ISM non-manufacturing numbers bounced back in June. I wouldn’t want to read too much into this yet; it simply should be the case that activity picked up across the economy as the first round of shutdowns ended. This is a diffusion index; improving business conditions from a very low level can be easy to accomplish in this circumstance but doesn’t necessarily signal the momentum needed to support rapid recovery. More importantly, the employment component remains under 50, indicating weak labor demand. Business might be up, but not enough to promote much needed job growth. That said, the numbers are all in the right direction.

Hiring spiked in the JOLTs report for May. This isn’t exactly news as the employment report revealed a surrise jump that month as firms rehired workers separated in the early stages of the pandemic. Attention is better placed on the level of job openings. Though still much higher than the lows of the last recession, the declines indicate caution on the part of firms. Also, the level of quits might be the most telling indicator here on the state of the labor market. Employees are wisely choosing not to leave their jobs, likely fearing it will be difficult to find another.

Initial unemployment claims and continuing claims remain stubbornly high. The second and third order impacts of the initial shutdown continue to force additional layoffs at a rate that exceeds the worst of the last recession. The need for ongoing enhanced unemployment benefits seems pretty clear here. It’s hard to throw people into a labor market where jobs continue to dry up, particularly if very sector specific weakness remains that prevents people from returning to their previous positions.

Fedspeak

In a Financial Times interview, Atlanta Federal Reserve President Raphael Bostic worries that the surge in Covid-19 cases will weigh on the recovery:

“There are a couple of things that we are seeing and some of them are troubling and might suggest that the trajectory of this recovery is going to be a bit bumpier than it might otherwise,” Mr Bostic said. “And so we’re watching this very closely, trying to understand exactly what’s happening.”

He correctly noted that more fiscal stimulus is needed. The original packages did not anticipate the crisis dragging past the summer as it most obviously will. Bostic is apparently cool on enhanced forward guidance:

“I think a lot of it depends on where we are. I do think that talking about the benchmarks that we’re looking at is an important thing,” he said.

“But I do worry that circumstances are going to be very different in the future than they are now and so I want to be careful about being too presumptuous about where we’re going to be. All this uncertainty is definitely in my mind”.

I am not entirely sure what he means, but it sounds like he is worried about committing the Fed to any particular policy path given the uncertainty. This quote sounds a bit wishy-washy to me. I don’t think the point of enhanced forward guidance is to presume where you are going to be. It is that you don’t know where you are going to be but you know where you want to go.

Dallas Federal Reserve President Robert Kaplan wants to strike at the heart of the problem. Via Reuters:

“How the virus proceeds, and what the incidence is, is going to be directly related to how fast we grow,” Kaplan told Fox Business Network in an interview. “While monetary and fiscal policy have a key role to play, the primary economic policy from here is broad mask wearing and good execution of these health care protocols; if we do that well, we’ll grow faster.”

It’s good to have the Federal Reserve authority from Texas reinforcing this message. Kaplan’s correct; monetary and fiscal policy will only take you so far. What the economy real needs is a public health solution to the virus.

San Francisco Federal Reserve President Mary Daly worries that unemployment will remain unacceptably high. Via MarketWatch:

“We don’t know how long it will fully take to put the virus behind us,” she said in a virtual chat held by the National Association of Business Economists. “I am assuming [unemployment] will level off at someplace we don’t want to be.”

What does this means for Fed policy? Richmond Federal Reserve President Thomas Barkin speaks the truth:

Asked if the Fed will have to do even more to help the economy, Barkin said: “Unemployment is 11%, so yes.”

Right now, any plausible scenario includes the Fed under continued pressure to do more.

Daly added that she is closely watching the possibility of nonperforming loans in the banking sector. That topic was also taken up by Federal Reserve Governor Randal Quarles. He sounded optimistic about the stability of the banking system:

Less than two weeks ago, we at the Federal Reserve concluded that our banks would generally remain well capitalized under a range of extremely harsh hypothetical downside scenarios stemming from the COVID event. Even with that demonstrated strength, however—given the high levels of uncertainty—we took a number of prudent steps to help conserve the capital in the banking system.

But he isn’t ready to take a breath of relief:

We know that the financial system will face more challenges. The corporate sector entered the crisis with high levels of debt and has necessarily borrowed more during the event. And many households are facing bleak employment prospects. The next phase will inevitably involve an increase in non-performing loans and provisions as demand falls and some borrowers fail.

This is obviously a space we should all keep an eye on – how well can the post-GFC financial system weather a series of bankruptcies?

Upcoming Data

The data flow picks up again this week. Tuesday we get the consumer price index for June; Wall Street anticipates that both headline and core decline by 0.1%. Fed officials also think that deflation will be the challenge going forward; obviously negative prints would reinforce their resolve to maintain accommodative policy. A surprise positive print would be ignored; a series of positive prints would be more interesting but very unlikely. Wednesday brings the industrial production report for June, which is expected to show the sector gained 1.4% as the reopening continued.

Thursday is a big day. We get the usual jobless claims data; the story there has been one of a very slow decline that is not consistent with a rapid recovery. June retail sales, however, are expect to explode 17.7% higher as consumers continue to make up the ground lost earlier in the year. How much that sticks in July now that Covid-19 cases are on the rise is a big question. We also get the NAHB home builder’s index for July which will be followed by the June housing starts (1.17 million expected) and building permits (1.28 million expected) data on Friday. The housing market has shown considerable resilience; continued strength in the sector would mean the economy would be on firmer footing to rebound when the pandemic eases. The preliminary Michigan Consumer Sentiment number also comes on Friday.

Watch also for the latest Beige Book on Wednesday; it is sure to be depressing. More interesting though will be a speech by Federal Reserve Governor Lael Brainard titled “Economic and Monetary Policy Outlook.” Sounds relevant.

Discussion

As we move deeper into the second half of the year, we face three big questions. To what extent does the renewed surge in Covid-19 cases slow the economic recovery from the first-wave of shutdowns? How much fiscal stimulus will Congress deliver? What will the Fed do to support the recovery?

There are no easy answers to the first question. Virus numbers are surging across the south and west, but will we see a return to stay-at-home orders or more modest interventions? My instinct is that we will see a mixed strategy of wearing masks coupled with sector specific shutdown such as the closure of bars in Texas, capacity reductions for restaurants, and the shutting of fitness centers. With continued fiscal support though, the economy could weather such a storm. To be sure, growth will be slower than desirable in the near-term, but longer-term growth requires controlling the virus.

How much would this impact Wall Street? In the category of “things that will make people unhappy,” leisure and hospitality is the icing on the cake in the economy. Even though the sector has grown in importance in recent years, it’s valued added was only 4.2% of GDP going into the crisis. The economy can transition away from a shock to this sector. The key is not to allow that transition to translate into cascading shocks to the financial system like occurred after the burst of the housing bubble (see Daly and Quarles above). That’s where fiscal and monetary policy can continue to help. Barring such a major meltdown, I suspect the rally on Wall Street can survive without keeping the bars open.

Given the deteriorating conditions in some states and resulting political impact to Republicans, my expectation is that we see a fiscal support package in excess of the $1 trillion max the White House wants but less than the $3 trillion passed by the House. A key element of any package is that some form of enhanced unemployment benefits will continue, although not with the $600 weekly add-on as before. Via CNBC:

Mnuchin said the White House wants to change rather than extend the enhanced unemployment provision. He did not give details on how it would want to structure aid to unemployed workers.

“You can assume that it will be no more than 100%” of a worker’s usual pay, Mnuchin said. He echoed Republicans who argue the generous insurance deters some people from resuming work because they make more at home than they otherwise would at their jobs.

This is a glass half full sort of situation. Realistically, the full additional $600 a week wasn’t going to last forever. From a market perspective though, a continuation of benefits at 100% for many workers would be supportive. More generally though, if you believe conditions will rapidly deteriorate in (formerly?) Republican strongholds in the next two weeks, I think you should expect the final numbers on the next pandemic response bill to climb higher. Yes, I understand this has the unpleasant implication that a worsening Covid-19 situation is a market positive.

The Fed will continue to lean toward easier policy; see Barkin above. With unemployment expected to remain high and inflation low, the Fed will be under enormous pressure to take further action. I expect that first in the form of enhanced forward guidance and then eventually yield curve control. See what I wrote last week.

There has been some notion of late that the Fed is deliberately moving in the opposite direction by withdrawing stimulus. This idea has gained some traction because the balance sheet has contracted a bit as the repo operations have fallen to zero. I don’t think you should interpret this as an intentional reduction of support by the Fed. It simply reflects better market functioning and more excess reserves such that the repo operations are no longer needed.

Three further points. First, the relationship between the Fed balance sheet and equity prices is murky at best. To the extent that the relationship appears, it is spurious. So I wouldn’t bet that a reduction in the Fed balance sheet resulted in a sustained decrease in stock prices. We already did that experiment. Second, the Fed already committed to sustaining the current pace of asset purchases:

To support the flow of credit to households and businesses, over coming months the Federal Reserve will increase its holdings of Treasury securities and agency residential and commercial mortgage-backed securities at least at the current pace to sustain smooth market functioning, thereby fostering effective transmission of monetary policy to broader financial conditions.

Third, realistically if market conditions deteriorate, the Fed will accelerate asset purchases if they feel necessary. Which altogether gets to the old story of “don’t fight the Fed.”

Bottom Line: If I am cautious going forward, it’s because I am worried that rising Covid-19 cases could turn market sentiment negative. I also worry that another shutdown risks cascading problems in the financial sector. I weigh those concerns, however, against my expectation that the next round of shutdowns will be more limited to sectors that are a fairly small part of the economy, that we will thus not see the general collapse in spending as we saw in the initial phase of the crisis, that we will likely get sufficient fiscal stimulus to limp along at worst, and the Fed will continue its efforts to support the recovery.

I staked out a position on yield curve control in Bloomberg Opinion:

The Federal Reserve might not be ready to explicitly target yields on U.S. Treasury securities to keep them from rising and hindering the economic recovery, but that doesn’t mean it won’t happen. If you believe the Fed will be under continued pressure to do more to support the economy, it’s tough to bet against the eventual adoption of so-called yield-curve control.

Recall that last week, the Fed signaled doubts about yield curve control. My expectation is that those doubts will eventually fade.

How do I arrive at such a conclusion despite the Fed’s reticence? My position assumes continued economic weakness, inflation persistently below target, and an eventual unwillingness on the part of the Fed to continuously ramp up the scale of asset purchases.

With a new wave of Covid-19 cases sweeping some states, particularly in the South and West, it is becoming increasingly evident that we will not experience anything like a V-shaped recovery. We are in this for the long haul; consumers are already starting to step back:

Credit card data thru July 1 confirm a dip in spending even in states where the virus is low and reopening is proceeding supporting the findings of @Austan_Goolsbee and @ChadSyverson that the fear factor and uncertainty about the future may dominate hospitalization/death rates pic.twitter.com/LP7VmYiKOS

— Julia Coronado, Ph.D. (@jc_econ) July 9, 2020

We have to assume that even in the case of a miracle vaccine, full recovery remains years away. If the last recovery is any example, inflation will remain persistently below the Fed’s 2% target. With that being the case, the Fed will be under constant pressure to DO MORE.

What does “doing more” entail? First up will be enhanced forward guidance. They will tie policy to economic conditions, likely weighted more toward realized inflation. Beyond that, they will want to move onto a tool they can escalate. They could escalate quantitative easing, but that commits them to a path of expanding the balance sheet at an increasing pace. Doing more with quantitative easing means $45 billion becomes $60 billion becomes $75 billion, etc. You get the idea. I think the Fed would eventually become concerned about the optics.

Alternatively, you could instead move toward yield curve control. The Australian experience is that once you establish credibility on the policy, you don’t need to actually buy any bonds. Plus, you don’t have to jump straight to three years out. You start at one year, then two years, then three years. That’s like a full year of “doing more” without escalating the pace of asset purchases.

You can argue whether this actually accomplishes anything. That’s fine, you don’t think the signaling alone has much value. Others think it does. Either way, you have an investment position. Note also that a turn toward yield curve control doesn’t necessarily preclude the Fed from doing more quantitative easing. I expect they would use the tools in tandem, yield curve control to lock down the front end and enhance forward guidance and asset purchases to reduce term premiums and force investors into less safe assets.

Of course, a surprisingly quick recovery or an outbreak of inflation would eliminate the need for additional policy. For example, Congress could in theory pump enough money into the economy to accelerate the return to full employment. It’s not my expectation, but it could happen and shift the path of Fed policy.

Bottom Line: Yield curve curve control seems too obvious a choice to easily dismiss.

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Surging Covid-19 cases reveal the fragility of the recovery. Still, the regional nature of the cases offers the possibility of avoiding a widespread shutdown like that of earlier this year. In such a case, the recover would remain slow, but would continue.

Key Data

It was widely anticipated that the jobs market would extend its May gains and the employment report did not disappoint. Employment rose 4.8 million in June while May was revised slightly higher to a 2.7 million gain; the unemployment rate fell from 13.3% to 11.1%. Wall Street embraced the report with market participants pushing the S&P500 0.45% higher.

On the surface, this was a good report in that it revealed an economy behaving largely as expected. Many jobs should come back quickly once lock-down restrictions eased. Economic conditions are improving, and it shouldn’t be a surprise that markets are reacting to that improvement.

That said, even a good report needs to be placed in context. Notably, the job gains to date are only a fraction of the 22.2 million jobs lost in March and April. In addition, while the broader U-6 unemployment rate, which captures measures of underemployment, improved by 3.2 percentage points, it still stands at 18.0%. We still have a long climb ahead of us to return to pre-Covid employment levels.

That climb back looks increasingly difficult. The early stage of the recovery will have dramatic gains such as seen in the last two months, but this is really just an artifact of the stop-start nature of this recession. Employment fell sharply because of the wide-ranging shutdowns of activity; some activity would certainly come back quickly. The recent pace, however, will certainly soon slow. A firm might be able to survive a month or two with no business, but a month or two of no business followed by 50% capacity will force it to either fold or employ fewer workers. This issue will be particularly prevalent in the leisure and hospitality sectors. Consequently, the job gains come back fast and furious at the beginning of the cycle but as the recovery drags on with subpar levels of activity, what where temporary job losses will become permanent losses. Indeed, this is already occurring with number of permanent job losses rising by 588,000 to 2.9 million.

Also important to note is that after the jump in average wages related to the initial change in the composition of the labor market because lower income people were the first to lose their jobs, average wages are now clearly in decline. I expect wage and salary declines will be much more common in this recession than the last as wages become less rigid in a downward direction, a testament to the size of the shock that struck the economy.

The Institute of Supply Management June manufacturing report revealed that the sector pulled back into expansionary territory. The logic behind the data is the same as that of the employment report. Many firms experienced a sharp and steep drop in demand and it was all but impossible that they would begin to stage a rebound with even a minimal improvement in demand.

Fedspeak

The highlight of the week was the minutes from the June 2020 FOMC minutes; I discussed the release here. The main surprise was that the Fed has yet to embrace yield curve control (YCC), a disappointing outcome to those anticipating a shift to YCC sooner than later. The Fed instead showed a preference from utilizing the existing tools of forward guidance and asset purchases. I think YCC is still likely, but that enhanced forward guidance will come first and then, as the recovery remains subpar, the Fed will feel pressure to do more and YCC will be the path of least resistance. Probably looking at 2021 before that happens.

San Francisco Federal Reserve President Mary Daly sees recovery in four to five years in the optimistic scenario. Via Bloomberg:

“If we can get the public health issues under control either through a really robust mitigation strategy or a vaccine, then we can reengage in economic activity really quickly,” Daly said Wednesday in a virtual Washington Post Live event. “Then it could take just four years or five years. But if we end up with a pervasive, long lasting hit to the economy, then it could take longer.”

Via the Wall Street Journal, New York Federal Reserve President John Williams sees the economy’s low point as behind us, but agrees that full recovery will take years. He downplayed the possibility of negative interest rates:

Mr. Williams said the choices the Fed will make will be determined by how the economy performs, and he offered no specifics about what sort of actions were on the table. But he pushed back at the notion the Fed might push its now near-zero interest-rate target into negative territory, saying guidance about the future direction of rates and asset buying offer more stimulative power.

Of all the things the Fed seems inclined to do, negative interest rates are at the bottom of the list.

Federal Reserve Chair Jerome Powell identified the most critical element of any recovery in his testimony to the House Committee on Financial Services:

Output and employment remain far below their pre-pandemic levels. The path forward for the economy is extraordinarily uncertain and will depend in large part on our success in containing the virus. A full recovery is unlikely until people are confident that it is safe to reengage in a broad range of activities.

More on that later. The general view is that the economy bottomed in April and has been gaining ground since, but the Fed is under no illusion about either the fragility of the recover or its role in sustaining the recovery. That role will require them to push policy further and they know it, they just don’t yet know the exact nature of that policy.

Upcoming Data

Fairly light data week. This morning we get a read on the services sector of the economy from both the ISM and Markit; the general expectation is improvement like seen in the general data flow. Tuesday brings the JOLTS report for May and its insights on labor market dynamics. The most important data of the week, initial unemployment claims, comes Thursday as usual. The pace of decline in the claims data has been disappointing; as faster pace of decline would provide an immediate boost to investor confidence. PPI numbers will be release Friday.

Discussion

The U.S. economic narrative is complicated. We know the economy has plenty of room for improvement and is in fact improving. But we also know that the recovery remains vulnerable to waning confidence among consumers due to surging Covid-19 infections. A wildcard in the mix is fiscal support; a premature reduction of fiscal support could light a fire at the base of the economy.

There is plenty of evidence that the economy is on the upswing. This had to happen once the lockdowns eased. Once activity fell to zero for many firms, there was nowhere to go but up. Unfortunately, Covid-19 infections are also on the rise with multiple hotspots such as Texas, Arizona, and Florida. Regardless of whether or not states renew lockdown orders, Powell’s concern that a lack of confidence will delay the pace of the recovery will be realized.

For example, the Wall Street Journal reports that dining is already taking a hit in states were Covid-19 cases are on the rise. This is a particular blow for restaurants that were counting a steady growth in customers to get them back on their feet. The simple fact of the matter is they can’t manage to operate without volume:

“Restaurants can’t live and survive by patio alone,” said Mr. Boomstra, a director in the firm’s restaurants practice.

I would expect a widening range of firms to see activity slow in places where the virus is growing unchecked. This, however, brings up a number of questions. First, will the virus hotspots lead to rolling slowdowns and closures or a virtual nationwide shutdown? If the former, the economy would likely manage to continue to climb forward albeit at a weak pace of growth. Second, will the embrace of masks in Texas lead to a general acceptance of masks as a pandemic fighting tool that turns the tide on the virus? If so, we could see cases roll back over by the end of the summer. Third, even if virus is brought under greater control later this year, will we be prepared for the fall and winter when many are driven back inside? Forth, even if we are not prepared, will there be a nationwide shutdown again by the end of the year?

Any of these paths lead to fairly similar monetary policy outcomes as none of them contains a rapid recovery. The economy has already sustained to much persistent damage in the form of firm closures and employee-employer separations. This explains the growing number of permanently unemployed (permanent in the sense that the previous job no longer exists). Without a rapid recovery, the Fed will be under pressure to take more action. Worse outcomes now will intensify the urgency, to be sure, but easier policy is coming sooner or later.

From an equity market perspective, these questions suggest a potential serious of sentiment shifts on the horizon. The worst outcome is of course a renewed nationwide lockdown. A series of rolling shutdowns would be less damaging and equity market participants would likely view such a situation as one of general improvement and thus try to look forward to the other side of this whole mess. That outcome, which seems highly likely suggest to me that further equity gains will be hard to come by. I am intrigued by the possibility that the cases begin a descent by the end of the summer; that situation would seem to set the stage of an equity rally.

A wildcard in this whole situation is the expansiveness of the next fiscal support package. The generally positive data flow could lead to a less expensive fiscal package. Such an inclination would be a mistake. The expanded unemployment benefits in particular are providing critical support at the base of the economy and is almost certainly the reason retail sales and consumer confidence are holding up better than might be expected given the magnitude of the shock. It allows workers to cover their fixed costs, which includes paying the rent and mortgage. Think of it as “trickle up” policy. If the base of the economy suddenly fell over a fiscal cliff at the end of this month while the virus prevents a full recovery and the second and third order impacts of the initial shock are still flowing through the economy, a cascade of bankruptcies and foreclosures could wreak havoc on the financial sector.

Because the negative consequences are so severe, I find it hard to believe that Congress won’t find a way to continue to pump money into households, albeit perhaps via less generous benefits.

Bottom Line: The economy is improving, but even in a best-case scenario the Fed will be easing policy further. They aren’t ready for yield curve control but I suspect will get there. Surging Covid-19 infections will sap confidence in the economy. Rolling shutdowns might not bring the equity market to its knees like we say in March, but they wouldn’t be supportive of further gains. Seems like more room for negative than positive sentiment this month, but watch for the possibility that case numbers roll over later in the summer. That might happen if mask wearing becomes almost universal and they work to slow the pace of infection. In any scenario, Congress needs to maintain fiscal support.

After months of staying at home, we were ready for some away-from-home social distancing. Oregon is a big state, and there are lots of places with very few people, which is what we were looking for. With that in mind, the kids and I packed two weeks worth of food and set out on a 1,200 mile road trip. Along the way I captured images of an Oregon outsiders might not find so familiar.

We began with a tour of the Oregon Outback / Christmas Valley region. First stop was Hole-in-the-Ground:

From there we crossed over the high desert to Fort Rock, seen in the center of this photo:

Fort Rock up close:

We made camp southeast of Fort Rock on Green Mountain and then visited Crack-in-the-Ground for a quick hike:

Christmas Valley at dusk:

The next day we traveled further southeast to Warner Vally. Hart Mountain rises up to the east:

Warner Valley contains the Warner Lakes chain of lakes and wetlands:

On top of Hart Mountain is the National Antelope refugee, with this shade-free campsite:

The mosquitoes were intense that night. The refuge is vast with panoramas like this:

We then crossed east to the Steens via the backroad highway:

We spent some time at the Steens, first at the Page Spring campground:

Which is on the Donner und Blitzen River:

Then at the Fish Lake campground:

It was stocked with rainbow trout; my son of course caught a trophy trout with the first cast (no picture because I was trying to get it back in the water ASAP). The Steens Loop road was still closed, so we trekked the 9 miles round trip in the blazing sun to Kiger Gorge:

Most people just drive right up to the Gorge. As least the lake was refreshing at the end of the day:

We circled the Steens first south then east to the Alvord Desert:

It’s kind of a thing to drive across the desert:

The east side of the Steens from the east side of the desert:

My original plan had been to camp in the desert and head further into the southeast part of the state, but it was in the mid-90s with no shade and the kids rejected this kind of campsite:

So we headed north, first to Mann Lake:

It’s attraction, according to the Bureau of Land Management:

Lake attracts anglers as much for its remote, rugged splendor as for its abundant Lahontan cutthroat trout. These trout are supremely adapted to survive alkaline desert waters and without them fisheries like Mann Lake could not exist. The lake was named for an early rancher and has satisfied fishers for over forty years. Anglers converge as early as March and into October. Shallow throughout its 200 acres, the lake features extensive weed beds and great shorelines for wading.

Unfortunately, the lake has suffered from some dry years and there were no anglers as far as the eye could see. Nor was there anyone else. Another rejected camping site.

The kids at that point rejected the desert entirely and asked for something more like classic Oregon. I relented and headed north for the Strawberry Mountain Wilderness. We spent a few nights in the area exploring Strawberry Lake:

and fishing for brook trout:

The region is not volcanic in nature like the Cascades and feels to me like the Olympic Mountains in Washington state. Eventually, it was time to head home with a quick tour of the John Day Fossil Beds area:

Overall, a successful trip. We almost made it without going into a store but I had to relent midway through for some milk and beer. I hope this photo tour introduced you to some new parts of Oregon!

The minutes of the June FOMC meeting reveal that the Fed is leaning toward enhanced forward guidance and away from yield curve control, at least for now. That said, the combination of forward guidance and the potential for yield curve control should continue to hold down the front to medium end of the yield curve for the foreseeable future.

FOMC participants discussed policy options when rates are pinned to the effective lower bound (ELB). The staff first briefed participants on the impacts of outcome-based forward guidance and large-scale asset purchases. This type of guidance links policy to specific economic objectives. The staff presented:

…results from model simulations that suggested that forward guidance and large-scale asset purchases can help support the labor market recovery and the return of inflation to the Committee’s symmetric 2 percent inflation goal. The simulations suggested that the Committee would have to maintain highly accommodative financial conditions for many years to quicken meaningfully the recovery from the current severe downturn.

Not surprisingly, the degree of effectiveness hinges on the capacity of the Fed to influence forward-looking expectations of firms and households. A more “prompt and forceful” policy stance could focus those expectations more effectively and accelerate the impact. Still, and most important for financial markets, is that the Fed would need to “maintain highly accommodative financial conditions for many years to quicken meaningfully the recovery from the current severe downturn.” In other words, we are in this for the long haul in the best-case scenarios where the Fed can accelerate the recovery.

The staff also briefed participants on the experience in the U.S., Japan, and Australia with yield curve control. The staff:

…noted that these three experiences suggested that credible YCT policies can control government bond yields, pass through to private rates, and, in the absence of exit considerations, may not require large central bank purchases of government debt.

But the staff also fretted that yield curve control might require the Fed purchase large quantities of debt such that “monetary policy goals might come in conflict with public debt management goals.” This is of course the type of situation the Fed fears as they perceive that fiscal authorities will strip the Fed of its independence should the Fed desire to raise rates. For what it’s worth, I am not convinced that this argument does not already apply to the existing quantitative easing regime. If the Fed wanted to pull back on the pace of asset purchases now, they might find themselves at the mercy of a Congress unhappy that the Fed basically cleared the way for expansive fiscal policy and then reneged.

Participants agreed that they had experience with asset purchases and forward guidance and that these are effective tools. They leaned toward outcome-based forward guidance and indicated that more guidance would be needed in the coming months, so be ready for it. A number of participants argued for tying policy to inflation outcomes. This stands in contrast to the original Evans rule which included both inflation and unemployment outcomes. The focus on inflation reflects the lessons learned in this past recession The Fed arguably tightened policy too early based on unemployment outcomes that pessimistically suggested inflationary pressures that did not become manifest. Given uncertainty about the strength of the Phillips Curve, the Fed appears to be leaning toward setting policy more heavily on inflation outcomes.

There was also a nod toward average inflation targeting in that the objective could “entail a modest temporary overshooting of the Committee’s longer-run inflation goal but where inflation fluctuations would be centered on 2 percent over time.” I think this foreshadows a shift toward average inflation targeting in the upcoming policy review.

A minority argued for an unemployment target or calendar-based guidance. A couple fretted about financial stability. I don’t think these views will dominate future discussions.

Regarding large scale asset purchases, participants believe these were also effective but were limited in current circumstances by the decline in natural real rates, the term premium, and the current low level of rates. It’s a pushing on a string argument. That said, asset purchases are still beneficial because they prevent unwanted increases in longer-term interest rates and act to reveal the Fed’s commitment to accommodative monetary policy. Per usual, there were a few concerns about financial stability.

In contrast to forward guidance and asset purchases, yield curve control did not get a lot of love from FOMC participants. Primarily, it appears the Fed did not think it necessary as long as forward guidance was effective. Then there were a number of concerns about actual implantation:

In addition, participants raised a number of concerns related to the implementation of YCT policies, including how to maintain control of the size and composition of the Federal Reserve’s balance sheet, particularly as the time to exit from such policies nears; how to combine YCT policies—which at least in the Australian case incorporate aspects of date-based forward guidance—with the types of outcome-based forward guidance that many participants favored; how to mitigate the risks that YCT policies pose to central bank independence; and how to assess the effects of these policies on financial market functioning and the size and composition of private-sector balance sheets. A number of participants commented on additional challenges associated with YCT policies focused on the longer portion of the yield curve, including how these policies might interact with large-scale asset purchase programs and the extent of additional accommodation they would provide in the current environment of very low interest rates. Some of these participants also noted that longer-term yields are importantly influenced by factors such as longer-run inflation expectations and the longer-run neutral real interest rate and that changes in these factors or difficulties in estimating them could result in the central bank inadvertently setting yield caps or targets at inappropriate levels. A couple of participants remarked that an appropriately designed Y

Here’s my take: Quantitative easing as a fundamental part of the tool kit was not quickly embraced by the Fed, yet policymakers have come to embrace it. Yield curve control will follow the same pattern. Assume the economy limps along with high unemployment. The Fed will be under pressure to do something. They will have a choice between expanding the balance sheet further with expanded asset purchased or:

appropriately designed YCT policy that focused on the short-to-medium part of the yield curve could serve as a powerful commitment device for the Committee. These participants noted that, even if market participants currently expect the federal funds rate to remain at its ELB through the medium term, the introduction of an effective YCT policy could help prevent those expectations from changing prematurely—as happened during the previous recovery—or that the size of a large-scale asset purchase program, which also poses risks to central bank independence, could be reduced by an effective YCT policy.

They will choose yield curve control. Hence, I think we should continue to view yield curve control as a credible option and the existence of that option combined with the upcoming enhanced forward guidance will keep the front to medium end of the yield curve locked down.

A couple of other points in the minutes are notable. First:

A number of participants judged that there was a substantial likelihood of additional waves of outbreaks, which, in some scenarios, could result in further economic disruptions and possibly a protracted period of reduced economic activity.

This scenario is already occurring in states such as Texas and Arizona. I continue to expect that the future is one of rolling shutdowns that weigh on overall economic growth. The state level response is not consistent and federal leadership is, shall we say, lacking.

A second point is that the Fed foresees permanent damage to the economy:

As part of their discussions of longer-run risks, participants noted that in some adverse scenarios, more business closures would occur, and workers would experience longer spells of unemployment that could lead to a loss of skills that could impair their employment prospects. In addition, to the extent that transmission-mitigation procedures adopted by firms reduced their productivity, or if the reallocation of industry output resulted in a lasting reduction in business investment, the longer-run level of potential output could be reduced.

The reference to productivity indicates a concern not just about a level-shift to potential output, but a trend-shift.  This reduced pace of potential output growth hasn’t shown up in the SEP yet, but participants are thinking about the possibility.

Bottom Line: The Fed isn’t ready for yield curve control just yet, but that doesn’t mean it isn’t coming. I suspect that they will move in that direction, but it probably won’t come until 2021 (assuming unemployment doesn’t look likely to quickly recede). Between now and then, be ready for outcome-based forward guidance focused on inflation.