FOMC Summary: A first look at the required conditions to raising rates

Tonight’s FOMC meeting was uneventful. Without much surprise, the Federal Reserve is committed to keep rates near zero through 2023 until it achieves maximum employment. In addition, QE stimulus will continue to support the flow of credit to the economy, with at least $120bn in monthly purchases. The FOMC statement notes that "over coming months the Federal Reserve will increase its holdings of Treasury securities and agency mortgage-backed securities at least at the current pace to sustain smooth market functioning and help foster accommodative financial conditions, thereby supporting the flow of credit to households and businesses”.

There has been mostly three points of interest:

• The update to the Fed Fund Dots, which included a first look at 2023, confirmed there is a majority of FOMC members considering rates will stay at the current level at least for two more years. Only four members see rates above the current range of 0.0-0.25% in 2023 (versus two members in July).

• The first Summary of Economic Projections (SEP) since June includes major changes to GDP and unemployment forecasts. The GDP forecast for this year has been revised upward at -3.7% vs -6.5% while forecasts for 2021 and 2022 have been revised downward, respectively at 4.0% (prior 5.0%) and 3.0% (prior 3.5%), thus confirming there is still a lot of uncertainty regarding the path of the recovery. Regarding the labor market, the Federal Reserve thinks the unemployment rate will recede back to 5.5% next year but it does not see it back to 4% until 2023. Finally, inflationary pressures are likely to remain subdued in the long run with CPI not rising above 2% over the considered period, up to 2023, according to the FOMC. In our view, the prerequisite for faster inflation rise in the next two years implies spiking oil prices, with is quite unlikely given the current imbalances in the oil market.

• The most important point tonight for investors is that the Federal Reserve has defined more explicitly the required conditions to raising rates. The FOMC statement notes that current interest rate range will remain until “labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment AND inflation has risen to 2% AND is on track to moderately exceed 2% for some time”. It constitutes a major change in reaction function for the Federal Reserve. In pre-COVID times, U-3 unemployment rate around 4% would have triggered policy normalization via rate hikes, as was the case in 2017-18. In post-COVID times, such conditions are not considered sufficient anymore to warrant at least one rate hike.

As widely expected, yield curve control was not a major point of discussion. In its latest minutes, the FOMC clearly put this option on the back burner due to risks to lose control over the size of the balance sheet (the Federal Reserve does not want to risk owing, let’s say, all Treasuries with less than 3 years to maturity) and due to uncertainty related to policy exit without causing market disruptions.

What was more surprising is that the Federal Reserve gave little insights regarding its new average inflation targeting scheme unveiled at Jackson Hole last month and how it will concretely work. Investors have been overthinking this but it is clear for the Federal Reserve, given tonight’s lack of information, that it is not the focal point of attention at the moment and that the central bank does not to tie up its hands by being too explicit.

The immediate market reaction to the FOMC meeting has been rather unspectacular. The yield curve has barely moved following the release of the statement – we cannot consider that half a basis point is a significant market reaction. In current market conditions, we expect that the short- and intermediate-term Treasury yields will remain stuck near current levels for some more time. In other market segments, like the junk bond market, investors and traders have apparently welcomed with relief the continued QE support from the Federal Reserve.