By Philip Marey of Rabobank
The FOMC meeting on November 4-5 will take place in a volatile environment, just after Election Day, while the country is dealing with another resurgence of Covid-19. What’s more, we are still waiting for an extension of the fiscal stimulus.
The election outcome could determine whether the Fed will have to provide more monetary policy accommodation to offset any shortfall in fiscal policy support to the economic recovery.
For Fed Chairman Powell there is more at stake than fiscal stimulus in this election week. After all, his first term as Chair expires on 5 February 2022.
Meeting in a storm
The next meeting of the FOMC is on November 4-5, just after Election Day (November 3), however it appears that Trump is now contesting the election results which show Biden in the lead across most battleground states. This means that the Fed will meet in a volatile environment. In addition to the elections, the country is dealing with another resurgence of Covid-19. What’s more, we are still waiting for an extension of the fiscal stimulus that expired at the end of July. Still, the FOMC may not be inclined to take any action before the election uncertainty subsides, unless there is some kind of market panic. Instead, in his press conference Powell is likely to stress again the importance of additional fiscal stimulus, and of getting Covid-19 under control. There will be no update of the economic projections.
Fiscal policy dependencies
The minutes of the September meeting showed that the economic outlook (and thus the FOMC projections) assumed additional fiscal support and that if future fiscal support was significantly smaller or arrived later than expected the FOMC thought the pace of the recovery could be slower than anticipated. Participants viewed fiscal support from the CARES Act as having been very important in bolstering the financial situations of millions of families, and a number of participants judged that the absence of further support would exacerbate economic hardship in minority and lower-income communities. District contacts indicated that fiscal policy had helped support small businesses, while federal aid payments had helped support farm incomes.
This means that the election outcome could determine whether the Fed will have to provide more monetary policy accommodation to offset any shortfall in fiscal policy support to the economic recovery. Until Tuesday, it was generally accepted that a Biden victory in combination with a Blue Wave in Congress would lead to a large fiscal policy package in the first quarter of 2021, followed by expansive fiscal policy during Biden’s first term. This would have been welcomed by the FOMC and allow the central bank to keep its monetary policy stance unchanged for now. In contrast, it now appears that we will get a “Divided Government” (the White House, the Senate and the House of Representatives are not controlled by the same arty) and we are likely to see gridlock at least until the midterm elections of 2022. This would mean only limited and delayed fiscal stimulus, possibly only after the economic data start to deteriorate severely. If fiscal stimulus proves insufficient to keep the economic recovery going, the Fed will be forced to provide additional monetary policy accommodation. However, the Fed has little ammunition left.
Yield curve control
Given the Fed’s aversion to negative policy rates, a faltering economic recovery and insufficient fiscal stimulus could push the Fed into yield curve control. By capping rates for a sustained period some additional monetary stimulus could be provided to aggregate demand.However, given how low longer-term rates are already, this will provide only modest support to the recovery. Alternatively, yield curve control could come into play if a large fiscal stimulus pushes up longer-term rates so fast and so high that they become a threat to the economic recovery. In this case the Fed may want to cap longer-term rates to maintain the current dose of monetary policy accommodation.
In addition to capping rates, the FOMC has the possibility to increase its asset purchases to provide monetary stimulus. In fact, much of the Fed’s plans regarding asset purchases has yet to be cleared up. From the minutes of the September meeting it was clear that the FOMC talked a lot about forward guidance on rates and very little on forward guidance on asset purchases. Some participants noted that in future meetings it would be appropriate to further assess and communicate how the asset purchase program could best support the achievement of the Committee’s maximum-employment and price-stability goals.
Another one term Chair?
For Fed Chairman Powell there is more at stake than fiscal stimulus in this election week. After all, his first term as Chair expires on 5 February 2022. While President Trump has become less critical of Powell after he cut rates to zero, he has a habit of replacing officials. For a President Biden the precedent of one term Chair Yellen will make it easier to change the Fed’s leadership after only four years. Keep in mind that Powell is a Republican, but more importantly there is likely to be pressure from the left to make the Fed more ‘socially activist’. In recent years the Fed appeared more concerned about limiting the downside risk of stock investors than about fostering income growth for ordinary Americans. While the ‘flexible average inflation targeting’ strategy (FAIT) that has been adopted recently is a step in the right direction, the wide dispersion of views regarding its implementation in the September statement suggests that we are heading for a chaotic exit strategy from the zero lower bound. And more importantly, it raises doubts about whether the FOMC will be able to resist the temptation to start hiking if inflation starts to pick up. Anyway, FAIT may not go far enough for the left wing of the Democratic Party. So Biden may replace Powell by a left-leaning economist who is eager to reshape the Fed’s strategy more radically.