Turkey’s Path to Policy Credibility – So Far, So Good
PGIM Fixed Income shares insights on Turkey’s central bank.
As was broadly expected, the Fed signaled at its meeting on September 16, 2020 that it would continue its stimulative policies to support the economic recovery for quite some time to come. In their updated projections, Fed officials collectively extended through 2023 the period during which the Fed funds rate is likely to be kept at its current near-zero level. And, as before, the pace of its QE purchases is expected to continue to run at least at a combined ~$120 billion per month ($80 billion Treasuries and $40 billion MBS, on net). The Fed stands ready to adjust these purchases as needed to support financial conditions and the economic recovery. Chair Powell also reiterated, though, that the course of the economy remains highly dependent on the path of COVID-19 and successful efforts to contain its impact. And he continued to cite a need for some form of additional fiscal support for hard-hit households and businesses as last spring’s support package begins to wane.
The meeting was the first since the Fed updated its Longer-Run Goals and Monetary Policy Strategy in August, which essentially implied a more dovish Fed over the course of the business cycle than was previously the case. The Fed’s new Policy Strategy now embraces: 1) average inflation targeting, whereby modestly above-2% inflation would be encouraged for a time to help offset periods of a 2% undershoot; 2) a more one-sided approach to the unemployment rate as a guidepost for appropriate monetary policy—an important reason for easing policy when high, but no longer a reason to pre-emptively tighten policy just because it is low; and 3) more focused attention on financial instability risks and their potential to derail the achievement of the Fed’s inflation and unemployment goals over the longer run.
In light of the new framework, some of the most notable information was in the Fed’s updated economic projections, with the horizon now extended another year through 2023. Given the better-than-expected economic data in recent months, the Fed marked its 2020 GDP estimate up to -3.7% from its June estimate of -6.5% and lowered its end-2020 unemployment rate estimate to 7.6% from 9.3% previously, similar to revisions by many private sector economists. Beyond 2020, the most notable aspect of the Fed’s revisions of these variables was the direction as the Fed not only lowered its projected GDP growth trajectory, but also lowered its projected path for the unemployment rate. The updates imply the unemployment rate is expected to improve at a somewhat faster pace relative to GDP than previously expected.
Probably the most interesting aspect of the Fed’s updated projections was in the inflation projections. Here, we think the implications were a bit disappointing, as they suggested a more tepid embrace of their new average inflation targeting regime than many Fed observers expected. The Fed’s updated inflation projections continue to show an inflation rate that runs moderately below 2% until 2023, when the newly added projection for that year shows it just reaching 2%. At no time over the 3 ¼ year horizon does the median Fed projection anticipate an inflation rate in excess of 2% that would counter the many years of undershooting. It is possible that Fed officials anticipate a very long period of inflation underperformance, despite their monetary stimulus. But the projections also could imply a less aggressive embrace of a 2% overshoot. Perhaps supporting this latter view, Minneapolis Fed President Neel Kashkari was one of two dissenters at this meeting, essentially arguing for a more forceful commitment to maintaining the current near-zero Fed funds rate until core inflation has reached 2% on a sustained basis. In addition to a less aggressive embrace from the Fed than initially hoped for, another potential consideration following the meeting is whether uncertainties exist about the ultimate effectiveness of the new inflation targeting regime.
The post press conference market reaction was muted, but cautious in tone—a marginally higher dollar and an uptick in Treasury yields as well as lower stock prices and wider credit spreads. Net net, markets seemed mildly disappointed, as if the Fed’s modifications to its framework as explained by Chairman Powell were somewhat less dovish than expected. While the changes seemed to be pretty much as advertised in advance, it was probably the subtle signals that tipped the markets towards skepticism. For example, when asked if the Fed would leave rates unchanged in the face of an asset bubble, the answer that its analysis is comprehensive suggests it would likely tighten in an asset bubble scenario.
So, while on the face of it, the policy of aiming for above-target inflation sounds aggressive, by the time Chair Powell had taken us through the small print, the markets were a bit dubious about just how much more aggressive, or effective, the Fed will be under the new regime. It may be that the most important aspect of the Fed’s policy tweak, aside from the low rate posture, is the commitment to continue bond purchases at least at current levels. This implies that if the post-COVID economic recovery flags—which could be a foregone conclusion given the lack of pre-COVID vigor—the Fed may step up its bond buying.
While perhaps not as accommodative as the market might have hoped for, all told, the Fed sounds committed to maintaining its dovish posture for years to come. The result should be positive for the credit markets by keeping Treasury yields rangebound and supporting economic growth, which should benefit the credit sectors over and above Treasuries. Over the long term, this should leave bonds well positioned to outperform cash. As for the Fed’s apparent anti-bubble bias, however, the new policy tack may at times end up favoring bonds over stocks—i.e., the Fed may now be more likely to tighten policy to avert an equity bubble as opposed to tightening policy to preempt a notable pickup in inflation. The one drawback of the whole exercise, however, is that the bond buying of the Fed and other central banks may be unwittingly enabling a dangerous accumulation of public and private debt across the global economy. So, while the investment backdrop is generally bullish, markets will likely continue to be plagued by episodic bouts of fear and volatility thanks to the overall configuration of slow growth, high leverage, and low policy rates.
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