Fed policy: What comes next?

Investors who have embraced risk since the depths of the pandemic just over a year ago have been well rewarded, with the S&P 500 Index up 85% as of April 9, 2021 since bottoming on March 23, 2020.¹ While there have been several catalysts for the move, including massive fiscal stimulus and the rapid development of vaccines, ultra-accommodative monetary policy from the Fed has been critical. By lowering the federal funds rate to nearly zero and indicating it’ll stay there for the foreseeable future, the Fed has provided the liquidity needed to fuel the rally. What might cause Fed officials to change their policy stance?

The Fed’s mandate is “to foster economic conditions that achieve both stable prices and maximum sustainable employment.”² If inflation and/or employment are slowing, the Fed uses its tools to encourage investment and growth. These tools primarily involve lowering the federal funds rate and quantitative easing, a fancy term for buying financial assets, especially bonds, to increase the money supply.³ Conversely, if it believes inflation is running too hot, the Fed may use those tools in the opposite direction to prevent the economy from overheating.

Today, the Fed has indicated it would like to see its preferred measure of inflation, the Core Personal Consumption Expenditure (PCE) Price Index,⁴ exceed 2.00% year over year “for some time” before it tightens monetary policy. On the jobs front, it would like to see the long-run unemployment rate fall to 4.00%.⁵ These targets had been in close range before the pandemic, with the U.S. unemployment rate at 3.50% and core PCE at 1.87% year over year⁶ in February 2020. Today, the unemployment rate is 6.00% and core PCE is 1.40%. While both are picking up as the economy reopens, we’re still some distance from the bullseye. This would argue against changes in Fed policy in 2021 and likely even into 2022 until we’re significantly closer to the target.

Following progress toward the Fed's dual-mandate bullseye

Source: fred.stlouis.org, chicagofed.org. Most recent unemployment data is through March 2021. Core personal consumption expenditures (PCE) data is through February 2021.

The tricky part with being at the 0% lower bound of the federal funds rate is that Fed cannot cut rates further to stimulate growth. It must use other tools, beyond quantitative easing, such as yield curve control, which involves targeting one or more longer-dated interest rates and buying or selling the necessary amount of bonds to achieve that targeted rate.⁷ The motive to use these nontraditional tools has been stated clearly by Fed Chairman Jay Powell: “I would be concerned by disorderly conditions in markets or persistent tightening in financial conditions that threatens the achievement of our goals.”⁸

Which financial conditions does Chairman Powell mean? In our view, he is looking at four key variables:

• Corporate bond spreads: Higher spreads would restrict corporate lending and growth.
• Stock prices: Weaker equity markets would reduce consumer spending power.
• Interest rates: Higher rates across the yield curve would adversely affect both corporate borrowing and mortgage lending rates.
• Currency markets: A stronger U.S. dollar could dampen export demand and weaken global growth, potentially creating a deflationary environment that would impede the Fed’s inflation objectives.

Wide high-yield spreads have implied difficult financial conditions

Source: FactSet, 3/31/21. High-yield option-adjusted spread (OAS) is from the Bloomberg Barclays U.S. Aggregate Credit Corporate High Yield Index. National Financial Conditions Index (NFCI) is from the Federal Reserve Bank of Chicago. Higher NFCI implies more difficult financial conditions.

Which of the four key variables would best signal that financial conditions were tightening? The chart above shows the extremely tight relationship between high-yield bond spreads and the Federal Reserve Bank of Chicago’s (Chicago Fed) National Financial Conditions Index.⁹ This index “provides a comprehensive weekly update on U.S. financial conditions in money markets, debt and equity markets and the traditional and ‘shadow’ banking systems.” The higher the index, the tighter, or more difficult, financial conditions are. The data suggests the Fed would only look to ease policy if high-yield spreads widen. Our base case is that the strong economic backdrop should keep spreads tight for now. That said, if high-yield corporate bond spreads do widen, then the easier Fed policy would likely be in the cards and provide a tailwind for U.S. Treasuries and intermediate to longer duration high-quality bonds.

So, we come back to the Fed’s dilemma. Should it worry about helping the economy get too strong, or should it be concerned with lingering potential for weakness and possible disarray? If you’re going to pick one thing to help you think about which way the Fed may be heading, you could do a lot worse than watching the direction of high-yield credit spreads. As they tighten, the Fed may be more inclined to do the same. But if spreads start widening, don’t be surprised to see the Fed go to its toolbox to keep conditions from getting disorderly.

1 Macrobond, 4/9/21. 2 chicagofed.org, 10/20/20. 3 forbes.com, 2/23/21. 4 
The Core Personal Consumption Expenditure (PCE) Price Index measures the prices paid by consumers for goods and services, excluding more volatile food and energy prices. It is not possible to invest directly in an index. 5 federalreserve.gov, 3/17/21. 6 fred.stlouisfed.org, 3/26/21. 7 brookings.com, 6/5/20. 8 msn.com, 3/4/21. 9 chicagofed.org, 3/31/21.