Happy holidays to all! This is the last Fed Watch of the year. Watch for big changes in this content coming in 2021.

The year is ending on a familiar theme of tension between the near- and medium-term outlooks. The high level of Covid-19 cases and the related negative impacts on activity dominate the near-term while the expected relief due to an increasing number of available vaccines dominates the medium-term. The Fed is focused on the expected improvements this spring and summer while leaving winter challenges to the fiscal authorities.

After a long delay with last-minute theatrics by President Donald Trump, Congress has authorized a new round of fiscal support for the economy that includes checks to families, enhanced unemployment benefits, more PPP money, and an eviction moratorium extension. The Fed will see this fiscal support as justifying its decision to hold the mix and pace of asset purchases steady at its December meeting.

Congress is currently debating an increase of the tax rebates from $600 to $2,000 per person. Trump and Congressional Democrats strongly support the proposal while it is getting a mixed reaction in the Senate. Senate Majority Leader Mitch McConnell looks to be trying to poison the move by attaching additional requests by Trump including an election review and the end of Section 230 protections for internet providers that are anathema to Democrats. Even if not passed, there is a growing sense that Democrats will win both the special Senate elections in Georgia; if that occurs, Democrats will control the agenda in 221 and $2,000 checks will be even more likely.

What happens to the past and fresh rounds of government stimulus is possibly the most important question for market participants in 2021. Incomes continued to outpace spending in November leaving the personal saving rate at a still-high 12.9% and further increasing the stock of excess savings accumulated since the beginning of the pandemic:

Watch for the saving rate to explode higher again as the government pushes out this fresh round of support. Large portions of the fiscal support will find its way into savings because fundamentally the U.S. economy suffers from a supply shock. It is not in aggregate that households don’t have the means or willingness to spend; it is that many of the traditional channels of spending are not available due to the pandemic. Eventually vaccine distribution will be sufficient to unlock the pandemic-impacted sectors of the economy, but for now you can’t buy what’s not available. We think of monetary policy as pushing on a string during a recession, but in this case we can also think about fiscal policy as pushing on a string.

So where does the fiscal support eventually end up? Certainly, some will go toward satisfying pent-up demand in leisure and hospitality; this will likely meet a temporary supply restriction that forces prices higher. Good spending might also get a boost, although that already is well above pre-pandemic trends; additional goods spending will likely be off-shored and have little impact on inflation. Some though will end up as a permanent increase in the level of saving and that will (I think) will continue to support asset prices. This arguably is already happening with stocks at record highs and a pace of home price appreciation not experienced since the housing bubble: 

It seems easy to tell a story where the Fed retains its current expected path of rates as they look through any inflation as transitory (attributable to a rebound in services spending) while asset markets continue to climb higher. This is the space I am thinking about as 2021 approaches.

Bottom Line: 2021 will hopefully be an improvement on 2020. Whether it will be or not depends on the success of vaccination campaigns. Optimistically, by mid-year the economy will be well on its way to normal. But what does normal look like given the magnitude of fiscal support pumped into the economy? We will soon find out.

The Fed met last week and held policy steady; see my commentary from last week. Expect that situation to remain until there is a material change in the medium-term outlook. To be sure, the near-term outlook is challenging, but the Fed views itself as having limited ability to affect economic outcomes during the timeframe in which help is needed. The message sent by Federal Reserve Chair Powell was fairly clear on this point. He was also quite clear that the Fed believed they were providing the appropriate amount of accommodation to financial markets.

The Fed also implicitly acknowledged it is not going to sit on the long end of the yield curve simply because rates are moving higher. As long as the Fed believes higher rates are attributable to expectations of stronger growth rather than either a misunderstanding of the Fed’s reaction function or a financial market disruption, they likely are not going to get in the way of higher interest rates.

Federal Reserve Vice Chair Richard Clarida re-affirmed Powell’s message in an interview last week that included a fairly optimistic outlook:

“I don’t think we will have a double dip,” Clarida said Friday in an interview on CNBC. “We’ve said we could have a rough couple of months in the data but on the other side of this of course we’ve gotten very, very positive news on multiple vaccines.”

The mixed nature of the data flow has been consistent with Clarida’s observation that the economy is in for a challenge but a double dip is unlikely. Core retail sales, for example, came in below expectations, slipping 0.5% in November:

That said, I don’t yet know what we should expect for number that is so clearly above it’s pre-pandemic trend. Do we expect a level shift or a reversion to the pre-pandemic trend? Unsurprisingly, there was some weakness in sectors most affected by the latest lockdowns. Food services dipped but the decline paled in comparison to this past spring:

Likewise, initial unemployment claims edged higher but again nothing the earlier carnage:

Meanwhile, industrial production edged higher in November

Even as the Covid-19 surge worsened in December, the IHS Markit flash numbers were a tad weaker but still robust:

Adjusted for seasonal factors, the IHS Markit Flash U.S. Composite PMI Output Index posted 55.7 in December, down from November’s 68-month high of 58.6. The rate of expansion was sharp overall, despite easing to a three-month low. The loss of momentum was most notable in the service sector, where additional restrictions and softer demand impacted consumer-facing business once again.

That’s really not much softness all things considered. The housing market remains solid. Although starts were roughly flat in November:

future starts, otherwise known as permits, rose 6.2%. This shouldn’t be surprising given the backlog of homes sold but not yet started:

The Atlanta Fed GDPNow forecast ended the week with an expectation of 11.1% growth for Q4.

Although we have a holiday-shortened week there will still be plenty of data to chew on. Tuesday brings the revised Q3 GDP numbers, an event that typically has little market relevance. More important will be existing home sales for November; sales are expected to be a touch weaker than in October. I wouldn’t read much into any weakness; the underlying market is clearly quite strong.

Personal income and outlays data for November arrives on Wednesday. We are anticipating incomes and spending to both be softer, the former as fiscal support ebbs and the later as the virus resurgence takes its toll but from a market perspective these are both short-term issues. Expect the savings rate to remain above its pre-pandemic level; the stock of saving to bolster the economy next year continues to grow. Inflation will likely remain at levels that ensure the Fed doesn’t have to think about raising interest rates anytime soon.

Also Wednesday comes November new home sales, expected to be a notch lower at 990k than the 999k pace of October. This would still be a super-charged rate. Finally, on that same day we also get December Michigan consumer sentiment numbers. Thursday (note: economic calendars have this scheduled for both Wednesday and Thursday) brings the usual initial claims report, likely to continue to edge higher. In addition, we get durable goods numbers. Core orders are expected to be 0.6% higher, extending the solid rebound this year, but note this can be a volatile series.

Some important items to watch this week. First, I thought a double-dip recession was unlikely to begin with and think it extremely unlikely now that Congress has reportedly reach a compromise on a fiscal support plan worth $900 billion that includes $600 direct payments for most people, renewed enhanced unemployment benefits of $300 per week, a fresh $284 billion for PPP, and money for airlines and transit. The liability shield and state and local aid were dropped from the negotiations. This is the bridge the Fed was hoping Congress would deliver to support the households and firms during the pandemic winter.

Second, in more disconcerting news, there appears to be a more infectious new variant of Covid-19 driving cases sharply higher in the U.K. Scientists believe that vaccines will still be effective with the new variant but it does raise the stakes for an efficient rollout of those vaccines. Time is clearly of the essence. At least 8 nations have announced U.K. travel bans; I would not be surprised by additional announcements. In other vaccine news, Johnson and Johnson announced that its vaccine candidate is moving forward with late-stage trials and expects to have data by late January. The vaccines keep coming.

Good luck and stay safe this week!

The December FOMC meeting concluded largely as expected with the Fed providing some additional guidance around the asset purchase program but declining to make changes to the program at this time. During the presser, Federal Reserve Chair Jerome Powell made clear that the Fed believes it is currently providing sufficient accommodation to support the recovery, he finds it unlikely that changing the asset purchase program will have a substantial impact on the time required for inflation to return to target, that the problem facing the economy is a near-term issue that can’t be effectively addressed with monetary policy, and that fiscal aid is the best (only?) tool that can address the economic impact of the current surge of Covid-19 cases.

That said, despite the Fed’s failure to change the asset purchase program this was still a dovish result. Four points to keep in mind:

• The description of the economy was unchanged and focuses on the level of the economy not recent growth:

The COVID-19 pandemic is causing tremendous human and economic hardship across the United States and around the world. Economic activity and employment have continued to recover but remain well below their levels at the beginning of the year. Weaker demand and earlier declines in oil prices have been holding down consumer price inflation. Overall financial conditions remain accommodative, in part reflecting policy measures to support the economy and the flow of credit to U.S. households and businesses.

The Fed doesn’t want market participants to focus on the pace of the recovery just yet as any signs of rapid growth might be taken as a signal that the Fed will raise rates sooner than expected. The Fed instead wants us to remember that the economy remains in a deep hole and as long as it is in that hole we should expect inflation will remain below target. And inflation below target means no rate hikes.

• The Fed updated its guidance on asset purchases to clearly link it to economic outcomes; we have no reason now to think the Fed will pull back on the asset purchase program until the economy shows substantial further improvement. The November language on asset purchases:

In addition, over coming months the Federal Reserve will increase its holdings of Treasury securities and agency mortgage-backed securities at least at the current pace to sustain smooth market functioning and help foster accommodative financial conditions, thereby supporting the flow of credit to households and businesses.

was updated to:

In addition, the Federal Reserve will continue to increase its holdings of Treasury securities by at least $80 billion per month and of agency mortgage-backed securities by at least $40 billion per month until substantial further progress has been made toward the Committee’s maximum employment and price stability goals.

The phrase “over the coming months” has a time-based element that felt inconsistent with the outcome-based guidance for interest rates. Now the Fed explicitly intends to hold the size of purchase at or above the current pace until the Fed achieves clear further progress toward its economic objective. Note though that “further progress” is not complete progress. The Fed will pull back on the asset purchase program before raising interest rates. When and under what conditions? Powell declined to answer that question but did promise there would be advance notice. Look for that notice to begin next year if the economy looks to rebound strongly as expected by mid-2021.

• The Fed sharply revised upward its economic expectations but held the rates forecast effectively steady. This is a de facto easing of policy. Consider the updated projections from the Summary of Economic Projections:

Remember, these are not an official forecast but they do provide an indication of which way the forecasting winds are blowing. Those winds are now blowing hard in a positive direction. The Fed now anticipates just 5% and 4.2% unemployment at the end of 2021 and 2022 respectively which, needless to say, would be a dramatically more rapid recovery than the experience of the last expansion. The Fed though does not see this expected improvement as reason to tighten policy.

One way to view this is that a faster than anticipated improvement in outcomes implies that the short-run neutral rate of interest is likely also rising more quickly than expected. Rather than trying to match that with a higher policy rate and holding accommodation neutral, the Fed is holding the policy rate constant thus in effect increasing accommodation.

• The Fed continues to set policy in accordance to its updated strategy. Even though the Fed see unemployment dropping close to its estimate of the longer run rate, 4.1%, at the end of 2022, this improvement has no bearing on the decision to raise or not raise policy rates. The Fed no longer sees closing the estimate unemployment gap as by itself a reason to hike interest rates. The Fed needs to see actual inflation sustained moderately above 2% to justify a rate hike. And with no such inflation expected, no rate hike is forecast. 

Bottom Line: Although the Fed did not change the asset purchase program, the new guidance and updated forecasts are together a dovish policy signal.

Today’s news highlights the dilemma facing the Fed at this week’s meeting. This, for instance, from Bloomberg:

The first Covid-19 vaccine shots were administered by U.S. hospitals Monday, the initial step in a historic drive to immunize millions of people as deaths passed the grim milestone of 300,000.

And this, also from Bloomberg:

New York is headed toward a second full shutdown if Covid-19 cases and hospitalizations continue at their current pace, Governor Andrew Cuomo said.

But we also have this from the New York Federal Reserve:

The November Survey of Consumer Expectations shows that consumers’ year-ahead spending growth expectations rose to 3.7 percent—the highest level in more than four years—despite flat income and earnings growth expectations.

Interesting, the spending outlook improved across all income groups but the gains among households making less than $50k were particularly notable:

The message is clear: The surge of Covid-19 cases this winter has had terrible health consequences and softened the economy in the near-term while the vaccine raises medium-term hopes and households are prepared to spend next year. The Fed will likely navigate this space by holding the size and composition of asset purchases constant while providing guidance on the path of the program. They can’t do much about the near-term but can stand ready to change the asset purchase program as needed if the economy struggles to rebound as spring approaches.

If the Fed surprises, they will do so by extending the maturity of purchases in some manner that matches the updated guidance. I wonder though that this sets the Fed up to disappoint market participants. What change is the Fed going to make that would have substantial impacts on the economy? It seems like the Fed would have to do something large to have such impacts but nothing indicates they are prepared for a substantial change in the asset purchase program. If the Fed shifts buying out along the yield curve, how far are they willing to go to hold down long rates? If the Fed doesn’t do enough to hold down long rates, it will engender expectations for more action. Is the Fed prepared to go big?

Separately, the Fed is updating the SEP’s information on the balance of risk into more user-friendly charts. Consider the diffusion of uncertainty and risk for participant’s GDP and core inflation outlooks:

With these visuals, the Fed’s decision not ease policy further already arguably demands some additional explanation. As of September, participants were very unconfident about the outlooks for growth and inflation while they saw the risks to the outlooks as weighted toward the downside. In other words, participants feared that their forecasts were too optimistic even though those forecasts anticipated a slow return to full employment and price stability. Why fail to take additional action when not only is the outlook soft but you think the outlook is both likely wrong and too optimistic? Market participants might reasonably be confused on your policy intentions with this kind of signaling.

I would like to see journalists push on Powell for a clear explanation of this disconnect (assuming of course that the Fed doesn’t move to ease policy further). The answer probably has multiple parts: Yes, the risks are on the downside but the high degree of uncertainty still includes the possibility of large upside surprises. Yes, meeting the Fed’s objectives takes a seemingly long time but it is within an acceptable policy horizon. The economy is simply in a deep hole that requires some minimum amount of time to correct. Yes, they could take further action but they may be concerned about the efficacy of additional policy when financial conditions are already very accommodative. Indeed, the Fed elevated the importance of financial stability in the recent update to its policy strategy; the Fed might be concerned about easing further into already loose financial conditions.

Fiscal stimulus negotiations continue, keep your fingers crossed. While the recovery may be self-sustaining absent additional support, such support would both increase confidence in a positive outcome and minimize the burden to households most impacted by the crisis.

Bottom Line: Regardless of the outcome of the Fed meeting we should get some additional clarity on the role the Fed believes it can play in the recovery process. It would be nice to pin down the Fed on the issue of if they can accelerate the recovery, why have they so far declined to do so?

It’s FOMC week. Last Monday I wrote about the upcoming meeting and incoming information has not changed my opinion. The Fed will most likely place some guidance around the asset purchase program but decline to make changes to the program at this time. I believe they will view the current Covid-19 surge as akin to a natural disaster where the most significant impacts occur in a time horizon in which they have little influence. Moreover, in comparison to this past spring 1.) the pandemic shock is much, much smaller, 2.) we know the speed with which the economy can recover on the other side, 3.) the other side now has a vaccine, allowing for even quicker recovery, and 4.) financial markets reveal no signs of distress and are instead are very well accommodated by the Fed.

The case for more easing at this time amounts too little more than the Fed has to “do something.” The risk to my forecast is obviously that they decide they have to “do something,” and that something will default to extending the average maturity of asset purchases. Comments in recent weeks by Fed speakers, however, suggest an inclination to delay changing the asset purchase program until next spring. But what kind of changes? We don’t know yet because we don’t know what the economy will look like. I would not assume though that they will decide net additions of accommodation are necessary.

The JOLTS data continue to provide room for optimism. October job openings failed to drop as would be normally the case in recessions and instead hold at 2016-17 levels:

Openings are even solid in sectors that would be expected to be weak:

The strength in manufacturing job openings is notable; it fits with anecdotal evidence in the ISM report that pandemic labor supply problems weigh on hiring. Quits also remain higher than might be expected using the model of the last cycel:

Finally, the Beveridge Curve continues to revert toward its pre-pandemic space in stark contrast to the last recession:

The dynamics of the JOLTS report appear more similar to what you would expect if the primary issue facing the economy was supply side rather than demand side.

Consumer price inflation surprised on the upside in November:The gains look to be related to transitory price shifts in the service sector more than underlying inflation strength. Importantly, shelter inflation remains weak:

My suspicion is that it will not be until the spring until we really start to think about interesting inflation stories and even then “interesting” is like 25-50bp.

The flow of funds data for the third quarter arrived this past week and revealed a new high for household wealth. In another contrast to the last recession, the strong housing market has supported housing equity wealth:

The drop in this metric is really about the denominator; personal income surged on the back of the fiscal stimulus. Interestingly, households might be starting to tap that wealth. Via Calculated Risk we see the first real uptick in mortgage equity withdrawals in a long, long time:

I can’t see the validity in the argument that the Fed needs to sit on the long end of the curve to support housing when housing is already red hot and homeowners may be at the front end of taking advantage of that market to boost their spending power in much the same way as they did during the housing bubble. Any expectation that the Fed needs to hold rates down for the sake of housing seem to me more like trying to fight the last battle than a realistic examination of this cycle.

Initial unemployment claims rose as expected but if you were looking for a repeat of this past spring, you were disappointed:

Claims will remain elevated until we move past the current pandemic surge.

We are looking at a moderately heavy data this week aside from the FOMC meeting. Industrial production comes Tuesday with markets looking for a modest 0.3% gain in November. In addition to the FOMC outcome, on Wednesday we get November retail sales. Wall Street anticipates a soft number with headline down 0.3% and core sales up 0.2%. The assumption is the spending party is over as the pandemic surge weighs on food and drinking services in particular. The case for an upside surprise to retail sales is that spending on services continues to be redirected toward goods spending and that shift will support a stronger than expected holiday shopping season. Markit/IHS numbers will also hit the screens on Wednesday. Thursday brings the latest update on the housing market with the anticipated flat housing starts numbers for November as well as the usual initial claims report. On Friday Federal Reserve Governor Lael Brainard will give a speech titled “Climate Change and Financial Regulation.”

Vaccine distribution in the U.S. begins this week. I would suspect some hiccups along the way, but mass immunizations are the light at the end of the tunnel.

Bottom Line: The pandemic surge will weigh on the U.S. economy this winter but we understand the economic implications with greater certainty than this past spring. It is easier now to look through to the other side, especially with a vaccine now available and more to follow. The Fed will likely also look through to the other side especially since their tools cannot operate in the relevant time frame and financial markets remain buoyant. 

Good luck and stay safe this week!

Note: This is a fairly expansive piece but it became a little long. That said, worth the time.

Introduction

In the wake of the less-than-spectacular though I think underrated November employment report research shops are rushing to tell clients that the Fed will most certainly shift the pattern of asset purchases out toward the longer end of the yield curve. I find this to be a curious position given that Fed speakers have literally said both implicitly and explicitly not to expect changes to the asset purchase program at this next Fed meeting. I have written on this once already but the topic deserves another examination given what will be increased attention on the Fed’s upcoming meeting. From my perch, there appears to be a communication error in the making. That said, I am going to lay out (again) the case for additional Fed easing and the alternative, and I think more likely, scenario.

Recent Fed Communications

Here are what I see as the prominent elements of the Fed’s recent communications:

First, the Fed wants to emphasize they are not considering raising interest rates. This is fairly straightforward. The Fed does not want to repeat the mistakes of the last cycle and engender expectations that its fundamental focus is policy normalization.

Second, the Fed’s new strategy suggests that public comments from FOMC participants will have a downward forecast bias, particularly for the near term. In one of my classes, we do an exercise in which the forecaster has an asymmetric loss function such that errors on one side of the forecast are more costly than errors on the other side. As a consequence, the forecaster should bias their forecast to minimize the odds of a forecast error on the “wrong” side of the distribution. The Fed has explicitly adopted an asymmetric loss function in its policy framework:

Owing in part to the proximity of interest rates to the effective lower bound, the Committee judges that downward risks to employment and inflation have increased.

The rational thing to do when you have such a loss function is to emphasize the downside risk. In other words, when making policy considerations, the Fed is biasing their forecasts down to mitigate the risk associated with being close to the effective lower bound. This supports an excessively pessimistic public position and one in which the Fed will say more policy support is likely needed even if an unbiased forecast says no such support is needed. This will encourage market participants to look for reasons to expect easing even if no such reasons exist.

Third, the Fed is “woke.” The Fed has long ignored the micro-consequences of its actions, choosing instead to focus on the macro story. In my opinion, this focus has in the past led the Fed to embrace the risk of higher unemployment in order to reduce the risk of inflation even though the latter hasn’t really been a problem. With the help of the Fed Listens events, the Fed now understands its error and how it inadvertently contributed to persistently high unemployment. The Fed now consistently reminds us that it has learned its errors with talking points such as this from the minutes:

Many participants observed that high rates of job losses had been especially prevalent among lower-wage workers, particularly in the services sector, and among women, African Americans, and Hispanics. A few participants noted that these trends, if slow to reverse, could exacerbate racial, gender, and other social-economic disparities. In addition, a slow job market recovery would cause particular hardship for those with less educational attainment, less access to childcare or broadband, or greater need for retraining.

This language, while accurate, contributes to a perceived negative bias in the Fed’s outlook. Note also that while some of these problems are cyclical in nature (a persistently strong job market will help alleviate the stress on lower-wage households) many are structural in nature. To some (large?) extent, they will not go away entirely even with a strong job market and require fiscal policy fixes. The Fed can’t fix everything. It’s going to be interesting how they at some point explain pulling back on policy when these equity issues haven’t been resolved.

Fourth, the Fed really, really wants more fiscal support for the economy. The Fed, rightly in my opinion, believes the immediate problems facing the economy require a fiscal response rather than a monetary response. My sense is that the Fed’s oft-stated concerns regarding the near-term outlook have more to do about maintaining public pressure on Congress to act rather than signaling a monetary policy response. Market participants, however, I think interpret the Fed as indicating they will attempt to compensate for a failure of Congress to reach a fiscal policy compromise.

Fifth, the Fed insists that its tools remain effective and it will use all available tools to support the recovery. Vice Chair Richard Clarida, recently said:

These large-scale asset purchases are providing substantial support to the economic recovery by sustaining smooth market functioning and fostering accommodative financial conditions, thereby supporting the flow of credit to households and businesses. At our November FOMC meeting, we discussed our asset purchases and the critical role they are playing in supporting the economic recovery. Looking ahead, we will continue to monitor developments and assess how our ongoing asset purchases can best support achieving our maximum-employment and price-stability objectives.

This seems to indicate that the Fed believes that can turn up the dial on asset purchases to support accelerate the recovery (but that’s wrong).

Sixth, the Fed is becoming increasingly aware of the medium-term upside risks to the forecast but often downplays those risks. Chair Jerome Powell, for example, in recent testimony:

Recent news on the vaccine front is very positive for the medium term.

But market participants can be forgiven if they can’t focus on that point given that Powell can’t either as the above points force him back to the near-term risks:

For now, significant challenges and uncertainties remain, including timing, production and distribution, and efficacy across different groups. It remains difficult to assess the timing and scope of the economic implications of these developments with any degree of confidence.

Altogether, the Fed’s messaging has been tilted toward a focus on the imminent downside risks to the economy, a need to avoid anything that might sound like they are revising the path of interest rates, that the economy needs more support, and that they have the tools to further support the economy.

The Fed Minutes Give Clear Guidance

The next step is to take the above communications and link them to the relevant forward-looking policy statements from the November Fed minutes:

Participants agreed that monetary policy was providing substantial accommodation, and most concurred that, with the federal funds rate at the ELB, much of that accommodation was due to the Committee’s forward guidance and increases in securities holdings. They judged that the current stance of monetary policy remained appropriate, as both employment and inflation remained well short of the Committee’s goals and the uncertainty about the course of the virus and the outlook for the economy continued to be very elevated. Participants viewed the resurgence of COVID-19 cases in the United States and abroad as a downside risk to the recovery; a few participants noted that diminished odds for further significant fiscal support also increased downside risks and added to uncertainty about the economic outlook.

Regarding asset purchases, participants judged that it would be appropriate over coming months for the Federal Reserve to increase its holdings of Treasury securities and agency MBS at least at the current pace. These actions would continue to help sustain smooth market functioning and help foster accommodative financial conditions, thereby supporting the flow of credit to households and businesses. Many participants judged that the Committee might want to enhance its guidance for asset purchases fairly soon. Most participants favored moving to qualitative outcome-based guidance for asset purchases that links the horizon over which the Committee anticipates it would be conducting asset purchases to economic conditions. A few participants were hesitant to make changes in the near term to the guidance for asset purchases and pointed to considerable uncertainty about the economic outlook and the appropriate use of balance sheet policies given that uncertainty.

One way to read this is simply that “more is better.” The Fed believes its policies are effective and that in the coming months they will maintain the pace of asset purchases “at least at the current pace.” The modifier “at least” implies that the Fed is biased toward more easing in the form of alterations to the asset purchase program. Via its communications the Fed has repeatedly agonized over the downside risks to the outlook and the costs of the recession to low wage workers and permanent scarring to the labor markets.  By all appearances then it follows easily that with risks of rising Covid-19 cases now realized, the uncertainty of fiscal policy, and the slowdown in job growth in November, the case for revising the asset purchase program is clear. The Fed will thus shift the pattern of asset purchases out toward the longer end of the curve.

If you are happy with that conclusion, you can stop reading here. But another way to read this section is to focus on what the Fed told you is going to happen next:

Many participants judged that the Committee might want to enhance its guidance for asset purchases fairly soon.

Is the Guidance In The Minutes Really Clear?

If you think the Fed is telling us that more easing is coming, a number of questions quickly leap to mind. If the Fed was so concerned about the pace of the labor market recovery and they had the power to accelerate the recovery, why has it not already acted? Moreover, if the reason they maintained the current policy was the risks to the outlook, doesn’t that mean they thought the current policy was too easy in the absence of such risks? With those risks realized, is current policy just right then? Does the Fed really believe that additional policy easing will ease conditions in such a way as to hasten the return to 2% inflation? Clearly given their medium-term forecasts they should already have done so. And what really can the Fed do to improve the economy in the near-term when we know policy acts with a lag?

An Alternative Take

The alternative take is fairly simple. With its focus on the downside risks the Fed has misled market participants into thinking the Fed will take action to counter those risks. The Fed instead see the risks as reason to retain the current pace and pattern of asset purchases but does not believe that anything they do now will help cushion the economy in the critical near-term time frame and is not yet certain whether additional easing is needed or helpful in the medium-term. Moreover, financial conditions are already accommodative and there seems little reason to think they need to be even more accommodative. Some points to consider:

First, with vaccine distribution now imminent, the medium-term upside risks looks increasingly likely to be realized. Everyone expects difficulty for the next two or three months, but the light at the end of the tunnel is now more clearly not an oncoming train. The Fed will have a clearer picture of the economy in just a few months.

Second, the Fed will be looking beyond the employment report to a wide array of indictors which have been sufficiently positive to drive the Atlanta Fed GDP estimate to 11.2% for the fourth quarter with two thirds of the quarter already complete. To be sure a weak-December will pull this estimate down, but much is already baked in the cake. The economy has more underlying strength and momentum than is commonly believed. Remember, it is not insightful to say the economy is slowing down from the third quarter crazy rebound growth.

Third, the employment report reveals not the weakness of the economy but its potential to rebound. Private sector job growth in November was 344k even after three months of rising Covid-19 cases. Considering the circumstances, that’s a win. Even a flat number for December would be a win in this environment. The Fed must be thinking if we can pull off these numbers with the virus, what is going to happen when the virus is in decline? You should be.

Fourth, if monetary policy acts with a lag, and we all agree it does, easier policy won’t do anything to help the economy right now when it’s needed the most. The Fed can’t do anything to ease the immediate pain. That’s why they want fiscal policy.

Fifth, there are essentially no signs of tight financial conditions. Financial conditions have been easing pretty much across the board:

Equity prices are at record highs, inflation expectations have rebounded to pre-pandemic levels, and corporate bonds spreads have fallen to pre-pandemic levels. What is the argument for the Fed to encourage even easier financial conditions? One argument is that the steepening yield curve represents tighter conditions due to rising long-term rates. One might make that mistake given that the Fed has said they can ease conditions by sitting on the long end of the curve. But that is a conditional statement. Never reason from a price change. The Fed will more likely want to sit on the long end of the curve only if they think it stems from a disruption to the financial markets or a “taper tantrum” misunderstanding. Neither appears to be the case now. The most likely reason for a steeper yield curve is rising risk of stronger economic growth in the future. Traditionally, a steepening yield curve is associated with economic improvement.

Sixth, if the Fed really thought they could ease economic conditions further and accelerate the pace of the recovery they should have already done so given its forecasts. The fact that they haven’t done so it fairly clear evidence that they don’t see a great deal of benefit in further easing.

Simply put, an easing next week has little upside and would be only for show.

But Why Hasn’t the Fed Pushed Back On Expectations For More Easing?

I get this question often. If the Fed didn’t like where market participants were headed, why haven’t they stepped in front of that narrative? The problem with this question is the Fed has stepped in front of that narrative, but nobody wants to listen.

Clarida was on November 16 asked point-blank about altering the asset purchase program and to ease financial conditions and reduce interest rates. His answer was I thought fairly straightforward (35:55 mark):

We are buying a lot of Treasuries, we’re buying $80 billion a month, that’s comparable to the pace of QE2 and its roughly the duration pull, so these are big programs, the mortgage program is quite substantial…with long-term yields at historically low levels and below both current and projected inflation, financial conditions are accommodative…we also look more broadly at access and availability to credit and, you know, the corporate bond market is functioning and capital is being allocated…the financial system is really supporting recovery…[story about term structure of interest rates]…an assessment about what the market is telling you, you really need to dig down a little bit…I was not concerned when the yield on the ten-year went from 80bp to 92 or, or whatever, you consider the range that it is in and it certainly still in a very accommodative range.

Clarida saw no need to increase asset purchases or sit on the long end of the curve. He clearly didn’t think additional easing was necessary and conditions have only become easier since then. What more of a signal do you want?

OK, so people want more I guess. But then comes San Francisco Federal Reserve President Mary Daly. Via Reuters:

“It is not the time to stimulate the economy aggressively and get people out in the economy because that would be unsafe,” Daly told reporters on a call after a talk at Arizona State University, held virtually. “I judge policy as in a good place.”

First, Daly is not some kind of hawk. Second, this is a strong position for a Fed president to stake out ahead of the FOMC meeting. Third, that’ some interesting logic. Daly is saying that encouraging more spending now just pushes people into contact with each other. In other words, easier monetary policy actually worsens the pandemic. This isn’t as crazy as it seems. It fits with a view that what the situation really needs is fiscal policy so that we can shut down the economy. Daly continues:

Though the Fed could deliver more support by skewing its $120 billion in monthly asset purchases to longer-maturity securities, Daly said, “I see no indication that markets are misunderstanding where we are headed and that we need to somehow do something different to get financial markets where we need them to be.”

That gets to the idea that the only reason to sit on the long end is if market participants are mistaken about the Fed’s rate path. But there isn’t a problem with market expectations. What might the Fed do instead? It’s already in the minutes, but Daly reiterates:

Though Daly said that giving more guidance on the Fed’s asset purchase program would be a “next natural step” for the Fed, she declined to give any contours of what that guidance could look like.

Ok, so maybe you don’t trust Daly’s signal. She’s newer. She’s on the west coast. I’m on the west coast too. What do we know about what’s going on? Let’s pull another dove then, this time Chicago Federal Reserve President interviewed after the labor report and via Nic Timiraos at the Wall Street Journal. Evans very clearly says they don’t need to revisit the asset purchase program until 2021:

“The risk characterization has improved,” Chicago Fed President Charles Evans said on Friday…

…“As we see progress each and every week and month, that really sets the pace for a better recovery in 2021,” said Mr. Evans. “We’re still looking to see how things are going to work themselves out” before making decisions about whether to provide additional stimulus, he said.

Ann Saphir at Reuters has more from Evans:

“I am not opposed to more accommodation,” Chicago Federal Reserve Bank President Charles Evans told reporters on Friday. But it won’t be until springtime, with the vaccine rollout underway and more clarity on the economic outlook, that “we’ll be able to make the judgment as to exactly what the pace of asset purchases should be, what the duration that we might want to think about taking out should be, and issues like that.”

Back to the Wall Street Journal on what is needed now:

Mr. Evans said he thinks it would be better to revisit any refinements next spring. If growth slows in the coming months, it would be better for Congress and the White House to agree on new relief funding. “Fiscal policy holds the promise to do something more quickly,” he said.

As I said earlier, monetary policy works with a lag. They can’t do anything about the immediate problem. Evans also sees the rise in yields as a positive thing:

“We’re trying to reduce borrowing costs” with asset purchases, said Mr. Evans. “But when the economy is stronger and everybody is demanding more and it’s easier to make good loans at slightly higher payoff rates, that’s actually a good thing for the economy.”

As I said earlier, a steeper yield curve is traditionally an indicator of stronger economic activity. This isn’t some new line of thinking. It’s old as the hills.

So that’s three FOMC speakers that have signaled that the Fed isn’t prepared to change the asset purchase program. A fourth is Dallas Federal Reserve President Robert Kaplan (a voting member). In an interview with the Nick Timiraos of the Wall Street Journal, Kaplan says his near term focus is on the financial markets:

What happens beyond the first quarter of next year will be something that we’ve got to be very cognizant of in thinking about the stance of monetary policy. So in the short run, I’m going to be monitoring to make sure that we don’t have a negative change in financial conditions so that we can help get through this next three to six months. But over the horizon, assuming that doesn’t happen, I’m more focused over on recovery heading into next year.

Again, all the Fed can do right now to support the economy is to ensure that financial conditions don’t tighten. And conditions are loose. Asked point-blank about changing the asset purchase program, Kaplan gives a straight answer:

WSJ: So assuming that financial conditions do not tighten in some extremely unwelcome way, would that call them for just keeping monetary policy where it is over the next three to six months?

KAPLAN: Yes, I think for now, there are some issues we’re going to have to decide on. What is appropriate timing of forward guidance regarding our asset purchases? We’ll have to decide when it’s appropriate to give that communication. Otherwise I’m not inclined to make changes to the stance of monetary policy unless there’s some change in the short run.

Think this through: Evans, Daly, and Kaplan were all at the November FOMC meeting and knew where the discussion was heading. Do you think any of them, especially noted doves Evans and Daly, are staking out super-strong hawkish positions relative to expectations in the week ahead of a controversial FOMC meeting when they expect to be on the losing side of the debate? Or do you think that they are staking out super-strong positions ahead of an uncontroversial meeting when they already know the outcome and want you to know the outcome? Do you really think they are playing some kind of three-dimensional chess by misleading us? And is it a coincidence that Evans stakes out that position literally the day before the blackout period begins?

None of this seems that hard. The Fed kind of screwed up the communications with all the emphasis on downside risk. They didn’t spend enough time explaining that the downside risk was very short-term and they really couldn’t do anything about it. They didn’t spend enough time saying that their tools are still powerful in response to a tightening of financial conditions but the economy fell into a deep hole and they can’t do much beyond create accommodative financial conditions that allow the economy to heal but that healing takes time. They have spent time explaining the importance of fiscal policy in the near term but haven’t until last week explained they couldn’t compensate for a lack of that policy because monetary policy works with a lag and by the time it kicks in we will be on the other side of the surge. That said, last month Clarida was very clear that financial conditions were accommodative and that more wasn’t necessary. I don’t know that anyone was paying attention.

Bottom Line: I don’t have some secret source that is telling me what is going to happen next week and I understand the inclination to think more easing is coming but I really don’t like predicting something that is the exact opposite what multiple Fed speakers are saying. It seems to me that the Fed is telling us they are going after the low-hanging fruit of putting some guidance on the asset purchase program at this next meeting. The Fed did discuss in November potential changes such as the duration mix or the size of asset purchase but this discussion regarded policy beyond the current surge of Covid-19 cases. With financial conditions currently easy and the Fed literally unable to impact near-term economic outcomes, there doesn’t seem any reason to change policy next week. Of course, an unexpected tightening of financial conditions would be something that the Fed could address should that occur between now and the meeting.

One of my reasons for medium- and longer-term optimism is the favorably demographic situation in the U.S. For years, we have been sinking into the demographic hole left behind as the Baby Boomers retired. The situation is now changing:

Traditionally, peak earning years begin in the early- to mid-40s. Beginning now, we are climbing the demographic hill where each succession year a larger population enters its prime earning years. For comparison, this is pretty much the same type of hill we were climbing in the 1990s when the Baby Boomers were aging into their peak earning years:

The earliest Baby Boomers were turning 45 in 1991. I have tended to think the aging of the Boomers into their peak earning years was an under-appreciated aspect of that era that was overshadowed by the dot com boom. To be sure, the Boomers represented a bigger jump in the peak earnings population, so I don’t expect the current demographic transition to pack the same punch. The trend, however, is very similar and I anticipate will be supportive of growth over the next several years.