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The Fed Reaches Into Its Policy Toolbox Again

The Fed Reaches Into Its Policy Toolbox Again

December 17, 2020
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The Federal Reserve (Fed) demonstrated Wednesday in its final policy meeting of the year—again—that it has not exhausted the tools it has for supporting the economy and still holds plenty in reserve. The Fed kept its target policy rate at 0–0.25% but sharpened its guidance on how long it would continue its bond purchase program, also known as quantitative easing (QE), at its current level. QE strengthens the Fed’s ability to influence longer-term rates. Market participants were skeptical at first that the new guidance was meaningful, but Fed Chair Jerome Powell made a strong case in his press conference that the change was substantive.

“Jerome Powell has become an increasingly effective communicator during his term leading the Fed, and the skills were on display Wednesday,” said LPL Chief Market Strategist Ryan Detrick. “He turned the market’s perception of a tepid micro-easing into the rollout of a new policy tool.”

The Fed is currently purchasing $120 billion of Treasuries and mortgage-backed securities each month, expanding its balance sheet dramatically, as shown in today’s LPL Chart of the Day. While the Fed has a strong influence on short-term market rates via its policy rate, it has much less influence on longer-term rates. In addition to increasing the amount of cash in the financial system to help ensure that it runs smoothly, the purchases soak up some of the supply of bonds, keeping prices for longer maturity bonds a little higher and rates a little lower.

View enlarged chart.

Many market participants were looking for the Fed to move toward buying longer-maturity bonds or increasing its purchases, both moves that would have increased its influence on longer-term rates. Powell noted during his press conference that both of those actions were still on the table if needed. But he also emphasized that the change the Fed did make was meaningful and loosely parallel to the updated policy framework it had rolled out earlier this year that allows inflation to run a little higher before the Fed raises rates.

The Fed’s focus on greater clarity around the timeline of its bond purchases makes sense. In the years following the Great Recession, the Fed ended its bond purchase program twice, only to have to restart it as the economy stumbled. It was more patient during the third round of purchases and was also more careful when communicating how it would wind it down, while also tapering bond purchases gradually. The Fed is building on those lessons.

Are there risks to the Fed’s new policies? In time, yes. The low-rate environment the Fed has created increases borrowing, hurts savers, and may contribute to asset bubbles. It may also contribute to long-term risks from inflation. Those are all genuine concerns. But for now, the Fed’s ability to demonstrate a steadfast commitment to supporting the economy and taking action to make that happen are more important.

 

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