The Fed: Unanswered Questions

The Fed: Unanswered Questions

Unanswered questions about future asset purchases could potentially undermine confidence in the Fed’s commitment.

The context for today’s Federal Open Market Committee (FOMC) meeting had a number of crosscurrents. On the one hand, the US economy has handily outperformed consensus expectations over the last few months. Consensus forecasts for growth and employment have been upgraded accordingly. On the other hand, the economic damage caused by Covid is still quite substantial (payroll employment remains 10 million jobs below where it was in February), and there are real concerns about the unevenness in the recovery across sectors and income groups.

Likely due to these multiple crosscurrents, many members of the FOMC had indicated a desire to wait for more clarity on the economic outlook before announcing any changes to policy. While the desire for clarity is perhaps understandable, waiting to make policy announcements risks undermining investors’ confidence in the Fed’s ultimate goals. Fed Chair Powell has previously said that the public should count on the Fed to be there to support a vigorous recovery. That type of statement suggests that the Fed’s support is not conditional on how exactly the next few months play out. To the contrary, in order for the public to have confidence in the Fed’s commitment, the understanding should be that the Fed will be there to support the recovery regardless of how the next few months unfold.

The FOMC decided today that it was better to go ahead and make some policy announcements sooner rather than later. Specifically, the post-meeting statement introduced forward guidance on the future path for interest rates. The acceleration of the forward-guidance announcement, even though the outlook remains somewhat unclear, was a surprise to many who thought the desire to wait for clarity would carry the day.

The guidance was also somewhat more ambitious than many expected. In particular, the guidance specifies a three-part test, in which all three criteria must be met to justify an increase in interest rates. In order for the FOMC to raise interest rates: (1) inflation must have “risen to 2%,” (2) inflation must be “on track to moderately exceed 2% for some time” and (3) the labor market must be at “maximum employment.” This is the first mention of inflation exceeding 2% in an official post-meeting statement. By including it today the FOMC is promising to make good on the new average inflation targeting framework.

The “maximum employment” condition is also notable. The focus on employment is consistent with the emphasis in Powell’s Jackson Hole speech at the end of last month. Moreover, as any student of undergraduate statistics can tell you, specifying a third condition necessarily lowers the probability that all the conditions will be met in a given period.

The announcements today were incomplete, however, as the FOMC left unanswered a number of questions about its asset purchase program. The post-meeting statement did include that the Fed will continue to purchase assets at least at its current pace ($80 billion of Treasury securities and $40 billion of MBS per month), and it also characterized those purchases as “fostering accommodative financial conditions.” What remains unclear is how long those purchases will continue and whether there will be any changes to the composition of purchases. Powell was pushed on both points during the press conference. His responses indicated that the FOMC has not yet decided, but it is considering all of the various dimensions of the program.

Our view had been that the magnitude of the current economic challenges, together with an unmistakably accommodative bias from Fed policymakers, meant the odds favored that the FOMC would continue its purchases for some time and eventually adjust its purchases toward longer-dated securities. The lack of progress today has made that outlook less clear, although it’s important to note that no options have been ruled out and the debate is ongoing.

At a higher level, leaving questions unanswered may have the unintended consequence of undermining investors’ confidence in the Fed’s commitment. That would be a shame, especially as the Fed appears to have gone out of its way to accelerate the forward guidance announcement in order to address precisely that type of issue.

 

Definitions

The Federal Open Market Committee (FOMC) is a policy-making body of the Federal Reserve System responsible for the formulation of a policy designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

The U.S. Federal Reserve, or “Fed,” is the central bank responsible for the formulation of a policy designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

A Mortgage-Backed Security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages.

U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.

Top

Important Information

 

All investments involve risk, including possible loss of principal.

The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested. 

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.

International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

Past performance is no guarantee of future results.  Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.

The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this material or its contents. This material may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this material may be restricted in certain jurisdictions. Any persons coming into possession of this material should seek advice for details of, and observe such restrictions (if any).

This material may have been prepared by an advisor or entity affiliated with an entity mentioned below through common control and ownership by Legg Mason, Inc.  Unless otherwise noted the “$” (dollar sign) represents U.S. Dollars.

This material is approved for distribution in those countries and to those recipients listed below. Note: this material may not be available in all regions listed.

All investors and eligible counterparties in Europe, the UK, Switzerland:

In Europe (excluding UK and Switzerland), this financial promotion is issued by Legg Mason Investments (Ireland) Limited, registered office 6th Floor, Building Three, Number One Ballsbridge, 126 Pembroke Road, Ballsbridge, Dublin 4, D04 EP27. Registered in Ireland, Company No. 271887. Authorised and regulated by the Central Bank of Ireland.

All Qualified Investors in Switzerland:
In Switzerland, this financial promotion is issued by Legg Mason Investments (Switzerland) GmbH. Investors in Switzerland: The representative in Switzerland is FIRST INDEPENDENT FUND SERVICES LTD., Klausstrasse 33, 8008 Zurich, Switzerland and the paying agent in Switzerland is NPB Neue Privat Bank AG, Limmatquai 1, 8024 Zurich, Switzerland. Copies of the Articles of Association, the Prospectus, the Key Investor Information documents and the annual and semi-annual reports of the Company may be obtained free of charge from the representative in Switzerland.

All investors in the UK:
In the UK this financial promotion is issued by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorized and regulated by the Financial Conduct Authority. Client Services +44 (0)207 070 7444

All Investors in Hong Kong and Singapore:

This material is provided by Legg Mason Asset Management Hong Kong Limited in Hong Kong and Legg Mason Asset Management Singapore Pte. Limited (Registration Number (UEN): 200007942R) in Singapore.

This material has not been reviewed by any regulatory authority in Hong Kong or Singapore.

All Investors in the People's Republic of China ("PRC"):

This material is provided by Legg Mason Asset Management Hong Kong Limited to intended recipients in the PRC.  The content of this document is only for Press or the PRC investors investing in the QDII Product offered by PRC's commercial bank in accordance with the regulation of China Banking Regulatory Commission.  Investors should read the offering document prior to any subscription.  Please seek advice from PRC's commercial banks and/or other professional advisors, if necessary. Please note that Legg Mason and its affiliates are the Managers of the offshore funds invested by QDII Products only.  Legg Mason and its affiliates are not authorized by any regulatory authority to conduct business or investment activities in China.

This material has not been reviewed by any regulatory authority in the PRC.

Distributors and existing investors in Korea and Distributors in Taiwan:

This material is provided by Legg Mason Asset Management Hong Kong Limited to eligible recipients in Korea and by Legg Mason Investments (Taiwan) Limited (Registration Number: (109) Jin Guan Tou Gu Xin Zi Di 016; Address: Suite E, 55F, Taipei 101 Tower, 7, Xin Yi Road, Section 5, Taipei 110, Taiwan, R.O.C.; Tel: (886) 2-8722 1666) in Taiwan. Legg Mason Investments (Taiwan) Limited operates and manages its business independently.

This material has not been reviewed by any regulatory authority in Korea or Taiwan.

All Investors in the Americas:

This material is provided by Legg Mason Investor Services LLC, a U.S. registered Broker-Dealer, which includes Legg Mason Americas International. Legg Mason Investor Services, LLC, Member FINRA/SIPC.

All Investors in Australia and New Zealand:

This document is issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 839, AFSL 204827).  The information in this document is of a general nature only and is not intended to be, and is not, a complete or definitive statement of matters described in it. It has not been prepared to take into account the investment objectives, financial objectives or particular needs of any particular person.

Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.

The aforementioned Legg Mason entities are wholly owned subsidiaries of Franklin Resources, Inc.