A Dovish Pause and a Repo Bazooka

December 13, 2019

Spotted dove looking back sitting on a tree trunk


USBAM's CIO, Jim Palmer, comments on the December 11th FOMC meeting.
Jim Palmer, Chief Investment Officer

As expected, the Federal Open Market Committee (FOMC) left policy rates unchanged this week. If anything, the meeting had a dovish tone with Federal Reserve (Fed) Chairman Powell giving himself wide room to maneuver by declaring, "Even though we are at 3.5% unemployment, there's actually more slack out there." This Fed isn't about to take the punch bowl away. 

Key details from the FOMC's December 11th meeting:

  • The federal funds target range was left unchanged at 1.50% to 1.75%
  • The interest rates paid on excess reserves and overnight reverse repos were left unchanged at 1.55% and 1.45%, respectively
  • The FOMC voted 10-0 for the policy actions, the first unanimous vote since the May 1st meeting
  • Monthly, the Fed will continue to purchase $60 billion in T-bills with remaining maturities of four weeks to one year at least into 2Q20
  • On December 12th, the New York Fed announced plans to offer $225 billion in overnight repo settling on December 31st and will auction an additional $190 billion in term repos maturing on or after January 2nd. These actions are in addition to year-end funding actions already taken.

I think we can take Fed complacency over repo funding off our year-end list of risks. Otherwise, not much to see here. The surprising strong November employment report bolstered the FOMC's case for ending mid-cycle rate adjustments and offered cover to remain on the sidelines for the next several meetings. The Fed Dot Plot showed no rate change in 2020, with the next projected move being a hike at some point in 2021 and a long-run target of 2.50%. I'd take those forecasts with a grain of salt - the FOMC is just reflecting its view current monetary policy rates are below neutral. Regardless, we see policy risk skewing toward patience and, if needed, more accommodation - with virtually no risk of a 2020 rate hike.

Of more immediate importance were Chairman Powell's thoughts on repo and year-end funding stress. The Chairman felt the combination of large-scale overnight and term repos along with continued T-bill purchases should be enough to manage year-end pressures. Importantly, the Chairman emphasized these actions were designed to ensure monetary policy decisions are transmitted to the fed funds rate and not to eliminate all volatility in repo and other markets. So, you've been warned. Sort of. As for making longer-term structural changes - regulatory adjustments to bank liquidity requirements, expanding Treasury purchases to include coupons, standing repo facilities - the Chairman made clear that was business for another day and all options needed more study. 

The Chairman also touched on the ongoing review of the Fed's operating framework for monetary policy, which is critical to guide officials on progress achieving the dual mandate of full employment and stable inflation. The goal of this review would be for the Fed to establish more objective standards for adjusting policy rates to avoid the verbal gymnastics and political pressure seen today.

The concept has a lot of merit. But I find one of the proposals floating around to be absurd - a policy that after consistently undershooting / overshooting inflation targets, the Fed would in turn allow inflation to run hotter / colder for an extended period to achieve its longer-run target of 2%. This method of forward guidance may make sense on paper but let's play things out a little bit.

First, let's assume the Fed is successful in re-igniting inflation and it ultimately runs in the 3% to 4% area for a longer than optimal period. Does anyone believe the Fed would implement policies designed to bring inflation down to, say 1%, to balance things out? No way. The Fed fears deflation more than anything and would never purposefully flirt with such low inflation. This policy is asymmetric from the start. Which makes it lack credibility. Which makes it unworkable. Second, if you think about it, 3.5% unemployment, 1.5% core inflation and 3.0% wage growth is close to economic nirvana. The Fed should be doing victory laps. Unfortunately, the proposed policy would require Fed officials to tell Americans - and their representatives in Congress - something like, "I know you've enjoyed having wages grow faster than inflation, but the party is over. We need to increase the prices you pay - a lot - to make up for past shortfalls. Trust us, it's our operating framework." Break out the popcorn for that one.

Instead, the Fed should just take the close brush with deflation as a windfall for consumers and look forward rather than worry about what has already transpired. Steadfastly asserting - and ultimately demonstrating - its willingness to let the expansion and inflation run out seems like a simpler and more effective plan to me.


Federal Reserve, FOMC Statement, projection materials and press conference, December 11, 2019

Federal Reserve, FOMC Statement, October 31, 2019

Federal Reserve Bank of New York, Repurchase Agreement Operational Details, December 12, 2019