All eyes on the Fed
At this week’s policy meeting, the Federal Reserve is expected to fine-tune its guidance on its asset purchase programme (currently running at USD120bn per month) and link the duration of the programme more explicitly to the "average inflation targeting" strategy the Fed announced in August 2020.
We therefore expect the Fed to provide ‘qualitative’ guidance on policy vaguely based on inflation and employment—although rate hikes are likely to be even further away than a reduction in quantitative easing (QE).
We had formed the view that the Fed could use the December meeting to announce 'Operation Twist' (shifting the emphasis of its monthly asset purchases on longer-dated Treasury bonds). But recent Fed comments suggest it may be disinclined to act for now, and instead decide to wait for more data before it makes its next move. This is because some Fed members seem willing to resist the financial market's constant longing for more accommodation. Although this resistance is likely to be temporary, Operation Twist may therefore have to wait until January.
The risk at this meeting is therefore something akin to 'accidental hawkishness'. In other words, doubts could be sowed among market participants if the Fed does not deliver anything beyond QE guidance—especially given the dire coronavirus backdrop and the ongoing failure of Congress to coalesce around a new fiscal stimulus. We expect more monthly QE in the first quarter of 2021, when the Fed will probably also launch Operation Twist.
We continue to believe the Fed’s implicit reaction function should be cemented further with Janet Yellen as Treasury Secretary. This is all the more true as the Fed cares about the government's borrowing costs (our 'soft MMT' thesis) and not just the business cycle and inflation. In particular, more QE could help absorb next year's big federal budget deficit (likely north of USD 2 trn). The Fed could also justify more QE by highlighting the recent lacklustre employment data and persistently low inflation.
Overall, despite potential temporary hesitancy, the Fed will not stand in the way of next year’s economic recovery. It could even help to fuel it further by keeping financial and housing markets buoyant.