US reaction: Fed continues to consider its options, while committing to be in it for "however long it takes"

• Policy was unchanged with FFR at 0.0-0.25%, forward guidance remained unchanged and the Fed committed to at least maintain the current pace of asset purchases.
• The accompanying statement was mainly unchanged, describing “sharp declines” in activity, but acknowledging improvement in financial conditions.
• The Fed published medium-term projections for the first time in six months. The Fed expects a slower rebound than we currently project for 2020, with more of a catch up in 2021.
• Fed Chair Powell described the recovery as following “a long road”, which much uncertainty.
• Powell also stated that the Fed was still considering how best to deploy its tools. It sees rates on hold through 2022, but sees explicitly forward guidance and/or yield curve caps as an open question.
• We expect explicit forward guidance with an unemployment threshold to be announced in September, but yield curve controls held in reserve.
• We expect balance sheet expansion to continue into 2021.

June’s meeting of the FOMC brought no change in policy. The Fed Funds Rate (FFR) was left unchanged at 0.0-0.25%. The Fed left its forward guidance unchanged in the accompanying statement, saying that FFR would maintain its range “until [the Fed] is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals”. In today’s announcement the Fed also committed to maintain US Treasury and mortgage backed securities “at least at the current pace”, a modest change from the “in the amounts needed” in April. This was all agreed by unanimous vote.

Beyond, these measures there was also little change in the economic description in the accompanying statement. This continued to describe “tremendous human and economic hardship” from the virus that had led to “sharp declines in economic activity and a surge in job losses”. The statement did acknowledge that “Financial conditions have improved, in part reflecting policy measures to support the economy”, but was otherwise unchanged on April’s statement. However, this time the Fed published Summary Economic Projections for the first time since December. Accordingly there was quite a change in that outlook.

GDP growth is now expected to be 6.5% lower Q4/Q4 2020 compared to 2.0% in December. The Fed then expects growth to rise to 5.0% by end 2021 and 3.5%  by end 2022. However, on balance the Fed saw little change in the US’s longer-term growth potential, forecasting a media reduction to 1.8% from 1.9% ( the central tendency falling to 1.7-2.0% from 1.8-2.0%).

At the same time the Fed expects the unemployment rate to remain elevated at 9.3% by year-end, before falling back to 6.5% in 2021 and 5.5% in 2022, with no change to the longer term unemployment rate, which it still sees at 4.1%.

Finally the Fed see headline PCE inflation at 0.8% in Q4 this year, rising to 1.7% by end-2021 and 1.7% end 2022, with ‘core’ inflation at 1.0%,1.5% and 1.7% - both suggesting some difficulty in re-gaining the inflation target, let alone achieving any overshoot – that we expect the Fed to commit to later in the year.

As no surprise to us, the Fed median expectation for its policy rate is for it to remain at the zero lower bound (but no lower through 2022, but at this stage the Fed has not adjusted its longer-term assessment of the neutral rate, which is currently 2.5%. However, the unanimity of participants decisions was striking. All participants expect rates unchanged this year and next. Only two participants expect a hike by end-2002 – one just 0.25% and one 1.00%.

Fed Chair Powell also delivered a dovish press conference. He left little doubt that the Fed would use the full extent of its tools for as long as necessary - not so much whatever it takes, but as Chair Powell said “however long it takes”. In terms of the outlook, Powell was characteristically keen to point out the elevated uncertainty, with developments also being governed by the path of the virus. However he stressed that despite the welcome positive surprise of the May payrolls report, this was a recovery that would begin in the second half of this year, but would follow “a long road”. What was also striking was the Fed Chair’s repeated discussion that unemployment had been the lowest in fifty years, with little signs of excessive wage growth and little impact on inflation, a place Powell said he was keen to return to quickly. There appeared little concern for future inflation at this point in time. This led Powell to discuss the Fed’s policy options. He highlighted the Committee’s protracted expectation for FFR at the current lower bound and said that market pricing suggested that markets understood this. He said that the Fed was still considering whether to adopt explicit forward guidance, but that outright yield caps were also being considered as an open question, with the Fed reviewing its own history and the experience of others with the policy. Powell also stated that as well as purchasing assets to continue to support smooth market functioning, they were also easing financial conditions. Powell was also repeatedly asked about fiscal policy: he said he thought that the policy response had been good to date, that Congress may have to do more, that more stimulus would quicken the recovery, but that that was a decision for them.

We fully recognise the Fed Chair’s hesitancy about providing “confident predictions, as opposed to just predictions”. With our concerns persisting about containment of the virus amidst a relatively early easing of restrictions across many US states, we still consider a relatively elevated risk of renewed acceleration of the virus as a key risk to the US outlook. That said, our own central forecasts if that outcome is avoided are more optimistic than the Fed presented today: we hope to see unemployment reach 7-8% in Q4, below the Fed’s >9% estimate and we forecast full year growth at -4.5%, more optimistic than the Fed’s estimate of Q4/Q4 2020 at -6.5%. We also expect to see CPI inflation close to zero over the coming months and into year-end, something that could see PCE inflation below the Fed’s 0.8% forecast. However, we fully expect to see further surprises to both outlooks over coming months. From the Federal Reserve’s perspective, we had forecast FFR on hold through 2022 before the meeting and Chair Powell’s highlighting of the lack of inflation pressures even with low levels of unemployment suggested that the Fed is not going to see any undue tightening of policy in anticipation of inflationary pressure, consistent with that outlook – Powell said the Fed was not “even thinking about thinking about” raising rates. However, there is clearly broader uncertainty around what the Fed will do next. At this stage, we expect the Fed to switch to a state-contingent form of forward guidance (from the vague “fully weathered” message at present) at the September meeting. Given Powell’s focus today, this could well be contingent on achieving labour market goals. We see this as likely to anchor the short-end of the curve effectively for the coming years, which we see reducing the need for explicit yield curve caps. However, this is clearly an open option for the Fed at this stage and future market reaction will likely govern whether the Fed ultimately uses this tool. Moreover, while the Fed has committed to current pace asset purchase for now, these will ultimately slow – probably after the summer – but we expect balance sheet expansion to persist into 2021.

Market reaction was mixed. Most markets recognised a more forcefully dovish Fed than had been expected. 2-year yields fell by 2bps to 0.17%, having been inching higher in recent days, while the 10-y note yield fell by 5bps to 0.73%, giving back much of the increase seen in recent weeks. The dollar also softened further, down 0.4% initially against a basket of currencies, at the time of writing it was down 0.2%. However, equity performance was confused – initially up 0.6% in reaction to dovish Fed forecasts, the index retreated as Fed Chair Powell explained why it would likely remain so dovish – anticipation of a long and painful economic recovery. At the time of writing, the S&P 500 index was back to initial levels having been 0.3% lower during the press conference.