Fed faces tricky balancing act in recession response

Federal Reserve officials are facing a delicate transition to the next stage of their response to the pandemic-induced recession, as they prepare to release their first economic forecasts in six months at this week’s meeting.

The Fed’s macroeconomic projections — which it declined to publish in March because the situation was shifting so rapidly — come after the US jobs report showed a surprising uptick in new hiring after two months of deep job losses, and in the middle of sharp rebound in stock prices.

Many economists are expecting Fed officials to signal that output will shrink by a big margin this year, with interest rates remaining on hold at zero for the next few years, which would reinforce their dovish stance and determination to keep monetary policy very loose.

“It will underscore that things are getting better but we are still miles away from full employment and price stability,” said Aneta Markowska, chief economist at Jefferies. “It’s probably going to take a long time before we get there so let’s not declare victory prematurely.”

But the Fed and its chair Jay Powell face a tricky balancing act at their meeting on Tuesday and Wednesday. Any hesitation in terms of their willingness to support the economy could disrupt markets, which have seen equities rally and yields on government debt rise.

“There is a real risk of a June 2013-type taper tantrum with rates and longer-term yields accelerating higher if the Fed is not resolutely dovish,” Krishna Guha and Ernie Tedeschi of Evercore ISI wrote in a note on Monday. “We think the Fed will signal that it remains . . . committed to using its full range of tools to promote the recovery.”

Since March, the Fed has slashed interest rates, dramatically expanded its balance sheet through asset purchases, and set up several facilities to lend to struggling entities across the US economy.

But a debate has been unfolding within the US central bank about its next steps, including whether it should be more precise and aggressive in its guidance on interest rates — tying any tightening of policy to specific milestones in the recovery — or set specific benchmarks for asset purchases.

While those discussions are likely to intensify this week, the Fed has not been feeling much urgency to settle on a specific option for now, as it tries to preserve policy flexibility.

“It is not difficult to look forward and see risk that could justify further Fed action — in particular the lack of fiscal help for state and local governments and the cliff in personal income that will come after July 31 when the extra unemployment benefits expire,” said James Sweeney, chief investment officer for the Americas at Credit Suisse. “But without those forward-looking risks being transmitted to financial markets, I don’t see a trigger for sudden Fed action.”

The employment data released last Friday will offer some comfort to the Fed that the labour market may have started recovering earlier than it imagined, but will do little to change its view that the US faces a long and painful recovery laden with risks, including the possibility of a second wave of coronavirus infections and shutdowns.

“They are not prone to over-interpreting one data point. They never are and they definitely aren’t when the data is so hard to measure,” said Julia Coronado of Macropolicy Perspectives. “They are going to look at it very differently than the market,” she added.

The economic and social impact of the mass protests unfolding in recent days across the US may also add a new element of uncertainty for the Fed.

“The good news and the hope, of course, is that over the long term that this is a catalyst for change and more equitable and sustainable growth. That’s really important. But in the near term you can’t escape the downside risk of surging infection, which was already high,” said Diane Swonk, chief economist at Grant Thornton.

The Fed meeting will offer Mr Powell a new chance to nudge Congress and the White House to reach a deal on new stimulus measures, on top of the $3tn already approved, especially since the enhanced unemployment benefits are due to run out next month and states and local governments are desperate for federal aid to avoid further lay-offs.

The Fed chair’s fiscal message could be particularly important since some Republican lawmakers are balking at a big package as they sense a turnround in the economy and do not feel additional spending is warranted.

“Powell’s not been shy at all, and that’s been a real pivot for him. He basically took off his Artful Dodger persona and was quite direct,” says Ms Swonk. “He’s a budget hawk yet he understands that the alternative is too costly not to do more.”