When Doves Fly—The Fed Updates its Stance

Sep 18, 2020 / By Charles Sherry, MSc
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Advisor TalkingPoints: It is not business as usual at the Fed; Powell has introduced a shift in how the Fed conducts policy. Prepare for client interactions with our monthly review including details on the Fed’s new direction, a progress report on the economy and a look at Q3 GDP and earnings.

While rock-bottom yields and low rates support higher valuations, a forward P/E ratio of 23 for the S&P 500 (Refinitiv) is well above the historical norm. We recognize a pullback is inevitable. Timing and estimating the magnitude of any correction, however, becomes much more problematic.

Against the backdrop of renewed volatility and the scars left by the Covid-induced recession, the Federal Reserve announced a shift in how it will conduct monetary policy. Bottom line, rates are likely to remain low for a long period. The impact on investors, savers and borrowers could be significant.

1. A kinder, gentler Fed

  • As the Fed’s view of the economy evolves, changes in how it implements policy and targets its dual mandates, full employment and price stability, would be expected to evolve, too.
  • Fed Chief Jerome Powell previewed the Fed’s “Statement on Longer-Run Goals and Monetary Policy Strategy” in a late August speech.
    • The new tone will have long-term ramifications, as it could keep rates low for a longer period.
    • It’s the first update since 2012.
  • What’s behind the change? Four key economic developments motivated the review.
    1. The Fed believes the long-run potential for growth has slowed, falling from 2.5% in 2012 to 1.8% today.
    2. The general level of rates has fallen at home and around the world. Estimates of the neutral federal funds rate have fallen substantially.
    3. The record expansion led to a strong labor market, with added benefits to those at the lowest income levels.
    4. The low jobless rate didn’t trigger higher inflation.
      1. The Philips Curve (the tradeoff between inflation and unemployment) broke down. Muted inflation was consistent with a 3.5% jobless rate.
  • The persistent undershoot in inflation is a cause for concern per Powell.
Figure 1: Muted Inflation

Source: St. Louis Federal Reserve July 2020

‘Statement on Longer-Run Goals and Monetary Policy Strategy’—a shift

  • There is no numerical goal for the unemployment rate.
  • The 2% inflation rate will be maintained.
  • Monetary policy must be forward-looking, as policy works with a lag.
    • So far, no changes.
  • A big shift: The Fed will seek to achieve inflation that averages 2% over time.
    • If inflation runs below 2% for a while, the Fed will allow it to run “moderately above 2% for some time.”
    • “Moderately” or “some time” was not defined.
    • Powell defined this as a “flexible form of average inflation targeting.”
  • Without an unwanted rise in inflation or the emergence of other risks, the Fed is signaling it won’t preemptively raise rates as it has done in the past.
    • Might we see a jobless rate below 4% and a fed funds rate near zero? Possibly.
  • Policy actions continue to depend on the economic outlook and any risks to the outlook, including potential risks to the financial system that could impede the attainment of its goals.
  • The Fed is trying to embed a modest degree of inflation back into the system without sparking financial imbalances, a tricky task.

September Fed meeting

  • In its September 16 statement, the Fed said it will “aim to achieve inflation moderately above 2% for some time so that inflation averages 2% over time and longer-term inflation expectations remain well anchored at 2%.”
  • The Fed plans to hold the fed funds rate at near zero until it believes this three-point test is met:
    • Maximum employment has been achieved.
    • Inflation has risen to two percent.
    • Inflation is on track to moderately exceed two percent for some time (my emphasis).
  • When asked at the press conference, Powell broadly defined ‘moderate’ as, “It means not large. It means not very high above two percent. It means, moderate.”
    • Regarding ‘some time,’ Powell said, “What it means is not permanently and not for a sustained period.”
    • It’s not rigid. There are no numeric triggers. It gives the Fed discretion.
  • Powell indicated he’s not particularly worried about stock market bubbles.

Economic projections

The Fed’s projections include:

  • No rate hikes are projected through 2023.
  • GDP is projected to fall 3.7% this year versus -6.5% in June.
  • The year-end unemployment rate is expected to be 7.6%, versus a 9.3% projection in June.
  • Estimating actual numbers is difficult in today’s environment. The wide range of projections encompassed in the quarterly update reflects the uncertainty.
  • What’s encouraging? The upgraded outlook reflects better-than-expected progress.

Bottom line for investors

  • The Fed has already pledged to keep rates low for a long time.
  • A flexible inflation target gives the Fed more wiggle room to hold rates lower for a longer period, i.e., it is signaling it will tolerate higher inflation, at least for a little while.
  • Very low rates, coupled with economic growth, have been a strong tailwind for stocks.
  • The Fed believes that global disinflationary forces will outweigh any inflationary ripples that may occur from its accommodative policy, as we saw in the last expansion.
  • The Fed’s guidance, coupled with well-anchored, market-based inflation expectations, could keep long-term bond yields low for an extended period.
  • But there are risks. Some fret that a very accommodative monetary policy and massive fiscal stimulus could lift inflation faster than the Fed expects.
    • Unwanted imbalances could materialize.
  • Might we begin to see too much complacency regarding low yields? Maybe, but odds favor a low fed funds rate for a long time.

2. Economic progress report

  • Table 1 indicates the economy hit bottom in April.
Table 1: Monthly Changes in Key Metrics
  March April May June July August
Industrial production -4.4% -12.9% 1.0% 6.1% 3.5% 0.4%
Manufacturing production -5.0% -16.1% 3.9% 7.5% 3.9% 1.0%
Retail sales -8.2% -14.7 18.3% 8.6% 0.9% 0.6%
Ex-autos, ex gas stations -2.4% -14.3% 12.3% 7.9% 1.1% 0.7%
Consumer spending -6.7% -12.9% 8.6% 6.2% 1.9%
Nonfarm payrolls (millions) -1.4 -20.8 2.7 4.8 1.7 1.4
Unemployment rate 4.4% 14.7% 13.3% 11.1% 10.2% 8.4%

Sources: St. Louis Federal Reserve, U.S. Census Manufacturing production excludes utilities and mining. It accounts for 75% of industrial production.
Consumer spending is a more broad-based category that encompasses spending on services not accounted for in retail sales.

  • We experienced a much sharper bounce than most analysts had anticipated in May and June.
    • In my view, the sharp stock market rally suggests investors were more optimistic.
  • Despite the uptick in Covid cases in June and July, the economy continued to rebound. However, the pace has moderated.
    • Still solid by historical standards but nonetheless, a moderation.
  • Table 2 highlights key economic data points and how much each has recovered from April’s low.
Table 2: Road to Recovery—Getting Back to Even
Industrial production 57%
Manufacturing production 67%
Retail sales 100%+
Ex-autos, ex gas stations 100%+
Consumer spending 76%
Nonfarm payrolls 48%

Sources: St. Louis Federal Reserve, U.S. Census
All data points August 2020 except for consumer spending: July 2020

  • Manufacturing production has clawed back two-thirds of its loss.
    • Industrial production lags amid weakness in oil and gas.
  • Retail sales have shined.
    • It’s a V-shaped recovery thanks to pent-up demand, and fiscal support via $1,200 checks and generous jobless benefits.
    • Let’s not discount job growth and the inability to spend on canceled events, vacations, restaurants and more, which appears to be funneling some cash into other sectors.
  • Consumer spending has lagged, as it includes spending on services and other categories that require person-to-person interaction.
  • The swift decline in the unemployment rate to 8.4% is encouraging, though it remains elevated. Few thought we’d see a jobless rate below 9% this quickly.
  • Notably, Fed’s September economic projections reflected a sharp reduction in the expected year-end jobless rate versus June.
  • The rebound in nonfarm payrolls has lagged economic activity.
  • Many analysts believe we still need fiscal stimulus, which may or not be forthcoming.
  • Powell said the economy has proved to be resilient in the lapse of jobless benefits.
  • A savings rate of 17.8% suggests there is still fuel in the tank to support activity.
Figure 2: Fuel in the Tank

Source: St. Louis Federal Reserve, July 2020

  • But uncertainty reigns.
  • Weekly jobless claims have been in a narrow range of 790,000–890,000 over the last six weeks (nonseasonally adjusted; claims fell 76,000 in the latest week to 790,000).
    • The still high level of layoffs suggests deep wounds won’t heal quickly.
    • A resumption of the downward trend would signal a higher degree of confidence in the recovery.
    • The DOL recently changed its methodology for seasonally adjusting claims to better reflect the impact of the virus on layoffs.
  • Separately, the recovery in housing, traditionally a leading indicator, has been strong.

A peek ahead

I. A Q3 rebound

  • The Atlanta Fed’s Q3 GDPNow model puts GDP at an annualized increase of 31.7% as of September 16.
    • September’s data could chip away at today’s estimate.
  • Yet, despite Q3’s rebound, layoffs remain high, signaling underlying problems haven’t dissipated.

II. Earnings

  • Q2 S&P 500 earnings fell 30.2% versus the July 1 estimate -43% (Refinitiv).
    • Covid’s effect has been considerable, but it has also created distortions that have benefitted some firms.
  • Q3 is forecast to fall 22% versus a forecast of -25% on July 1.
  • While year-over-year growth is not expected to turn positive until Q1 2021, Q2 S&P 500 operating earnings of $28/share is likely the bottom.
  • Q3 is currently projected to tick up to $32.55/share.

Charles Sherry, MSc, is a financial writer who is passionate about delving deep into the markets and leveraging communication to improve the client experience. He has almost 25 years of industry experience, including six years authoring the highly-rated Schwab Market Update. Charles is a writer and speaker who works primarily with financial advisors, providing timely content for newsletters, blogs and social media. The goal: bolster client engagement and increase advisor visibility. Learn more at www.financialjumble.com or contact him at charles@financialjumble.com.


IMHO the Fed expects inflation and wants credit for letting it happen. The fact is that taxes remove inflation from the economy, along with newly printed money. The Fed doesn't control taxes.

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