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Fed Powells at the Moon

Karl Schamotta December 16, 2020

In its latest decision, the Federal Reserve said it would keep monetary stimulus flowing until it sees “substantial further progress” in employment and inflation – explicitly linking future policy changes to the achievement of economic objectives, while stopping short of providing meaningful definitions of those objectives.

During the press conference held after the release, Chairman Jerome Powell noted that “recent news on the vaccines has been very positive”, but “it remains difficult to assess the timing and scope of the economic implications of these developments”. He said that asset purchases would continue until employment levels moved “substantially closer” to the central bank’s objectives – and that markets would be notified “well in advance” of any changes.

On a more quantitative front, members of the central bank’s rate-setting committee kept the benchmark overnight interest rate in a target range of 0% to 0.25% and made no changes to the composition of ongoing asset purchases. The central bank is widely expected to stretch the average maturity of its bond buying at some point in the next year – a policy change designed to counter a flood of Treasury issuance and keep long-term yields under pressure – but with financial conditions already in extremely accommodative territory, there appeared no compelling reason to do so at this juncture.

The official statement was bundled with an updated Summary of Economic Projections in which officials issued sharply-upgraded their economic forecasts, but also maintained a consensus view in which interest rates would remain near zero until 2024. Gross domestic product is expected to shrink 2.4% in 2020, versus the 3.7% forecast in September – and growth is seen rebounding toward 4.2% next year. Unemployment hits 5.0% in 2021 and 4.2% in 2022. The long-run Federal Funds rate is forecast to stay near 2.5%, unchanged from previous projections.

This underlines an evolution in the central bank’s reaction function – a desire to keep policy accommodative despite an expected strengthening in the real economy – that has truncated the “dollar smile” that drove exchange rate movements for decades. Under smile dynamics, the dollar tended to outperform when the US economy was very weak and global investors sought safety (the left side of the smile) or outperform when the US economy was growing, and the Federal Reserve was forced to begin hiking rates (the right side of the smile). With markets now expecting tightening to happen at a much longer delay, the conditions are seemingly in place for sustained weakness.

Indeed, the dollar continues to fall on currency markets, with a perfectly brewed combination of fiscal spending and economic optimism combining with the Fed’s tolerance of rising growth rates to inject caffeine into the global risk trade. Hopes for a UK-EU trade deal are intersecting with signs of economic stabilization on the Continent to lift the pound and euro. Rising commodity prices are pushing the Australian dollar higher, and incredibly loose financial conditions are propelling the credit-sensitive Canadian dollar upward. And the Chinese yuan remains in the ascendant.

Exchange rates may be heading for an overshoot – they almost always do – but with the Fed continually reiterating its commitment to keeping the global financial system well-supplied with dollars, any correction could take months to arrive.
Karl Schamotta
Chief Market Strategist