The messages coming out of the June FOMC (Federal Open Market Committee) meeting have not dramatically changed PIMCO’s outlook for Federal Reserve policy: Over the coming months, we expect the Fed’s focus will continue to shift from one of crisis management to one of keeping financial conditions easy. And as its objective shifts, the Fed will likely provide additional, more tangible, guidance on the path of monetary policy, including the path of interest rates and asset purchases. A yield curve targeting policy later this year is a distinct possibility. According to the June summary of economic projections (SEP), the majority of FOMC members expect to keep the policy rate at the effective lower bound through 2022. The committee also clarified that, for now, it will continue to purchase U.S. Treasuries and agency mortgage-backed securities (MBS) “at least” at the current pace – in line with our expectations.
Steady state of asset purchases should support easy financial conditions
Since mid-March 2020, when the Fed stepped in to help stabilize severe dislocations in U.S. Treasury and agency MBS markets, the Fed’s System Open Market Account (SOMA) has swelled to over $7 trillion (up from a $3.7 trillion trough in September 2019). More recently, as markets have pulled back from the brink, the Fed has gradually reduced its pace from purchasing $375 billion in Treasuries per week in early April to roughly $20 billion per week currently. Agency MBS purchases have exhibited a similar pattern.
On Wednesday, the Fed confirmed it will continue asset purchases at least at the current pace, while maintaining flexibility to adjust the pace as warranted by changing market conditions. We believe the Fed will purchase at the current pace of $80 billion per month in Treasuries and roughly $40 billion per month in agency MBS (net of prepays) until it is confident in the U.S. recovery – meaning at least through year-end 2020.
As we mentioned in our blog post following the April FOMC meeting, this purchase pace should offset much of the additional agency MBS and Treasury issuance that we expect in 2020 from the various pandemic relief measures.
No tangible guidance yet, but policy rate is likely on hold at least through 2022
The committee did not change the formal forward guidance in the June FOMC statement, noting that the current fed funds rate level will be maintained until the FOMC is “confident that the economy has weathered recent events.” However, eventually – and likely in September, coinciding with the release of the conclusions of the monetary policy review – we expect more tangible guidance on rates.
What does tangible guidance mean? Instead of using calendar or “date-based” guidance like it did in 2011 before transitioning to the unemployment and inflation thresholds in late 2012, the Fed will probably tie the path of rates to inflation and unemployment rate outcomes. And unlike in December 2015, when the Fed began hiking rates because it believed the economy was at or near full employment, we think Fed officials will wait until inflation actually returns to the 2% PCE (personal consumption expenditures) target before hiking this time. This rate guidance strategy is consistent with inflation overshooting the Fed’s longer-term 2% goal and should support inflation expectations, which had started to drift lower before the pandemic.
The June summary of economic projections (SEP) provides a glimpse into the FOMC majority thinking on the path of rates, even absent any formal changes to the current statement guidance. And consistent with our expectations on the path of rates, the median SEP projection for the fed funds rate remained at 0.125% through 2022 (we won’t have initial 2023 projections until the September meeting), while the majority of FOMC members forecast a prolonged period of low inflation and labor market underutilization.
Yield curve targeting could strengthen forward guidance
Eventually, the Fed could move to a yield curve targeting framework to further strengthen the credibility of its forward guidance by pinning down short and intermediate rates. In particular, the Fed could offer unlimited purchases of Treasury securities with maturities less than two to three years at yields above 25 basis points, which should stop markets from pricing in rate hikes and tightening conditions before the Fed has sustainably reached its goals.
As the markets are pricing the fed funds rate to be on hold well past 2022, there currently appears to be little need for the Fed to announce a yield curve targeting policy. However, in the context of the rebound in economic activity that started in May (which we expect will be acutely reflected in third quarter growth), it will soon be more natural for markets to consider the risks of tightening.
Separately, markets could also question the credibility of Fed guidance. Chair Jerome Powell’s current term is up in early 2022, and markets may price in some probability of the Fed reneging on previously communicated policy if a new chair is appointed.
Overall, without a yield curve target, the Fed may risk stifling the recovery in the event that yields react more dramatically to better data or to a shift in the leadership or composition of the FOMC.
Working out the details
Although we think a yield curve targeting policy is a distinct possibility, there are still some questions the Fed needs to address to effectively communicate the policy, and how it will evolve. For one, a yield curve target is implicitly a form of calendar-based guidance, which we think the Fed would prefer to avoid. Ultimately, we think the Fed could recast the policy by linking the implicit calendar date to economic outcomes and the Fed’s own forecasts. For example, if the economy progresses in line with the Fed’s forecasts, the Fed could slowly reduce the maturity of the target, allowing markets to pull forward the timing of the first rate hike embedded in forward interest rates. If the economic outlook worsens, the Fed could push out the peg, or vice versa if the economy improves faster than expected.
Another question that the Fed will have to address is whether to pursue a yield curve targeting strategy for short to intermediate yields while also continuing a policy of fixed purchases of longer-dated bonds. A yield curve target implies the Fed is willing to sacrifice control of the quantity of bonds it purchases – the main policy tool in the current large-scale asset purchase programs – to control the level of yields. We think implementing both strategies is possible, but it might cause confusion among market participants if not clearly communicated.
We believe Chair Powell when he says that the Fed will do what it takes to support the recovery. This recession has been marked by the deepest contraction and the fastest return to growth in modern history, but full economic healing will take time. During this time, we believe the Fed will seek to support the economy by keeping markets functioning and financial conditions easy. Continuing the current pace of asset purchases, and eventually committing to keeping rates on hold through 2022, will help ensure easy financial conditions and support the recovery.
Please see PIMCO’s “Investing in Uncertain Markets” page for our latest insights into market volatility and the implications for the economy and investors.
Tiffany Wilding is a PIMCO economist focusing on North America and a regular contributor to the PIMCO Blog.