Superficially, the December 2019 FOMC was a dovish hold, though there’s more than meets the eye. And the two ‘big’ reveals of the December 2019 FOMC meeting were that Powell & Co expect monetary policy to remain on hold throughout 2020 and that the Fed’s recent liquidity injections could be expanded to the buying of short term Treasury bonds, and not just only Treasury bills. But don’t call it QE (yet).

Starting with the mundane stuff, the FOMC statement was in line with expectations, with the economic paragraphs copy-pasted from the October meeting, which, in turn, were nearly identical to the September paragraphs on the economy. So, consumption is propping up GDP growth, while business investments and exports remain weak, both showing no growth this year. Judging from the statement, the Fed was less worried about global growth and trade tensions than it was six weeks ago.

The infamous dot plot contained no hike for 2020 – the median forecast that is. Most FOMC members did pencil in hikes for 2021 and 2022, forecasts which Powell subsequently tried to downplay. Without actually saying it, Chair Powell made very clear he doesn’t like the dot plot. Unfortunately, he apparently can’t do away with it anytime soon. So, we’re all stuck with it.

To be sure, an apt description of the dot plot is that the ‘dots’ represent FOMC members dreams, not forecasts. No, we’re not spacing. We’re not on drugs. The dots always show growth returning to potential, unemployment nice and stable around its natural rate and inflation always miraculously settling at 2%. But in reality the forecasts are never realized. Hence, the dots represent the FOMC collectively spacing out. We digress, of course.

The real message that Powell wanted to convey is that policy is still on hold until core inflation according to the Fed’s preferred measure is at or somewhat above 2.0%. The relationship between the output gap and inflation is weak. Thus, unemployment will have to stay low(er) for longer before inflation picks up further. Note that core inflation is currently in the 1.5% range, which isn’t terrible.

At the same time, Powell refused to describe the conditions that would justify further policy easing. That’s a hawkish bias, even if unintended. Furthermore, the FOMC’s estimate of the real neutral rate of interest is somewhere between 0.5% to 1.0%, though some Fed staff believe it’s actually at minus 1%. The real short rate, defined as the federal funds rate minus the annual change in PCE core inflation, is currently at zero. According to Powell the FOMC believes policy is currently accommodative. We clearly disagree, and this sets the Fed up for a disappointment next year, when it finds out inflation refuses to budge.

Turning to the troubles with short term rates, Powell made clear that the Fed is studying a number of measures that would safeguard the Fed’s control over short term rates. One of them is expanding asset purchases to short term Treasury bonds instead of only bills, which the Fed currently buys at a monthly pace of $60 billion. Presumably, expanding asset purchases to bonds would allow the Fed to reduce its footprint in the repo market. Other options include easing regulatory constraints, which would allow increased interbank trading in reserves, and coordinating with the Treasury at some point on the level of the cash balance it holds at the Fed. For the uninitiated, the Treasury’s cash balance at the Fed is the biggest autonomous liquidity draining or liquidity supplying factor over which the Fed has no direct control. Furthermore, according to Powell the Fed could also expand the current repo operations, but not with the intention of taking away all the year-end volatility in money markets.

So, will the Fed’s footprint in markets increase in the final weeks of 2019? If yes, probably only marginally. There’s currently enough ‘unborrowed’ capacity in the repo operations. In other words, banks haven’t maxed out repo borrowings at the Fed by a long shot. If markets become turbulent again, the Fed could simply increase its lending limits and/or pull forward Treasury bill purchases. Easing regulations, coordinating with the Treasury and buying short term Treasury bonds seem like a 2020 stories. In case of bond buying, it probably only commence after another or a couple of FOMC meeting.

AFS GROUP AMSTERDAM

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