The Federal Reserve is “not even thinking about thinking about raising rates”
The US Federal Reserve, as anticipated, maintained the Federal Funds Rate (FFR) in the range of 0% - 0.25%, at its meeting on June 10th. The Federal Reserve expects to maintain the FFR at the current low levels until: i) there is strong evidence that the economy has weathered the adverse effects from the pandemic; and ii) the economy is on track to return to maximum employment and the symmetric 2% inflation target. There was broad consensus among participants at the FOMC that these prerequisites will not be met until at least the end of 2022, with only two participants expecting any FFR increase from current levels in that timeframe. Markets continue to price in the likelihood of negative short-term interest rates during the course of 2020, despite policymakers’ hesitant view regarding the merits of setting interest rates below zero (see graph below).
Furthermore, the Fed provided explicit guidance regarding asset purchases. Recall that, following a surge in purchases between early March and early April to stem the initial shock from the pandemic to liquidity and broader financial conditions (the balance sheet increased from $4.2tn to $5.8tn on April 1st), the pace of purchases slowed steadily, with the balance sheet standing at $7.2 tn as of June 3rd. According to the latest FOMC statement, in order to safeguard smooth market functioning and to continue fostering financial conditions, the Fed will increase its holdings of Treasury securities and agency residential and commercial mortgage-backed securities “at least" at the current pace of $80bn and $40bn per month, respectively. Moreover, large-scale overnight and term repurchase agreement operations will continue. According to our estimates, the Fed’s balance sheet will end-2020 at over $8tn (40% of 2019 US GDP).
Both the meeting’s statement and Fed Chair Powell’s press conference communicated a cautious tone regarding economic developments. The recent and positively surprising improvement in the labor market — with the unemployment rate declining by 1.4 pps to 13.3% in May — was acknowledged. Nevertheless, it was also highlighted that the unemployment rate remains extremely high and it was likely distorted on the downside in May by c. 3 pps, according to the Bureau of Labor Statistics, due to technical issues. Indeed, circa 4.5mn workers were misclassified as employed but absent from work instead of unemployed on temporary layoff. The median FOMC participants’ estimate for the unemployment rate stands at 9.3% (on average) in Q4:2020, 6.5% in Q4:2021 and 5.5% in Q4:2022, still well above the long-term (median) estimate of 4.1% as well as the recent multi-year low (3.5% in February 2020).
The respective estimates for headline PCE inflation stand at 0.8% yoy in Q4:20, 1.6% yoy in Q4:21 and 1.7% yoy in Q4:22 (broadly below target). Recall that actual PCE inflation was 0.5% yoy in April and, according to the Federal Reserve Bank of Cleveland’s Inflation Nowcasting model, it reached a trough of 0.4% yoy in May. Turning to US GDP, the median FOMC participants’ estimate stands at -6.5% yoy for Q4:2020, followed by +5% yoy in Q4:2021 and +3.5% yoy in Q4:2022. The range in participants’ GDP forecasts was wide (e.g. from -10% yoy to -4.2% yoy for Q4:2020 and from -1% yoy to +7% yoy for Q4:2021), due to high uncertainty surrounding economic prospects (see graph below). The anticipated economic recovery is highly dependent on imponderable factors such as the evolution of the pandemic (second wave), the respective medical developments (vaccine, therapy), as well as the behavioral responses of economic agents (households, corporates).
However, risk assets were hit hard in the past week following the recent increase in COVID-19 infection rates is some US States (Arizona, Florida), as well as in Beijing (localised lockdowns), coupled with investors’ disappointment due to the lack of new policy measures by the Fed. Overall, global equities declined sharply by 4.5% on a weekly basis, EUR and USD Speculative Corporate bond spreads widened by 40 bps-80 bps, while Core Government bond yields declined by 15-20 bps as investors bid-up for safe haven assets (see Markets Section for details). Nevertheless, the Fed confirmed on Monday (15/6) that corporate bond purchases under its SMCCF program (announced on March/April) will begin on June 16 (up to $250bn) supporting risk-appetite with equity markets higher on both sides of the Atlantic. The end date of SMCCF remains September 30 2020.