As the chart shows, the Fed rates have been at the lowest possible level of 0.00% to 0.25% since March 2020, when the risk of COVID first emerged. While ruling out negative rates, the Fed in its September FOMC meet had signalled that Fed Rates could remain at these levels for next 2-3 years. That was brave but did shift the focus away from rates. So, what exactly do the latest minutes say?
Fed minutes underscore accommodation and monetary shift
In early November, the US was in the midst of presidential elections. Hence, not much was expected from the meet. However, the minutes brought out two things clearly. Firstly, Fed officials have reiterated their conviction that the current pace and composition of the Fed approach was broadly effective in fostering accommodative financial conditions. The Fed also gave an implicit assurance that the change at the helm of the US government would not affect the tone of the Fed policy.
The more important announcement was around the Fed balance sheet. This refers to the Fed holdings of bonds in its balance sheet. Normally, as a means to keep liquidity buoyant in the market, the Fed buys bonds in order to infuse liquidity. The chart below gives an idea of how liquidity infusion in the last one year has impacted the Fed balance sheet.
The pace of balance sheet expansion in the last one year of COVID has been twice the expansion during the global financial crisis of 2008-09. Back then, the Fed balance sheet expanded from $1 trillion to $2.50 trillion. However, between Jan-20 and Nov-20, the Fed balance sheet has expanded from $4 trillion to $7 trillion.
FOMC officials at the November 2020 Fed meet, therefore, deliberated on the ways it couldsignal future changes in bond-buying policy. With Fed rates almost at zero levels, the only instrument left with the Fed to signal accommodation or tighteningwas the bond buying program.
Fed has signalled likely expansion ofits balance sheet
Despite a balance sheet size of $7 trillion, the FOMC officials have hinted that they could expand accommodation through liquidity infusion. In short, the Fed was likely to enhance its bond purchase soon. However, the FOMC has also pointed out that they may do this in more innovative ways rather than just buying bonds.
• FOMC is did not want the market to speculateand worry that bond purchases would change any time soon.
• The first method is to buy more bonds but with a balance sheet of $7 trillion, the Fed may be a tad cautious.
• Instead of increasing the bond purchases, the Fed may buy the same amount of bonds but of longer maturities
• Another option is the quantum of bonds purchased and the maturities may remain the same but Fed may buy bonds for a longer period of time
• One more thing the Fed could do is to front-end its bond purchases so that the bigger impact is felt immediately.
Virus impact is far from over and that is the message
The Fed wanted economic revival to mean two things; revival in GDP and revival in jobs growth. The revival in GDP appear to be happening as the pace of the fall is abating and estimates for CY20 hint at contraction rate lower by 100-120 bps. But the impact on jobs is not encouraging. The pandemic resulted in a lot of structural changes to the job market like work-from-home (WFH), reduced travel, distributed operations and use of cloud. That has limited the salutary impact on jobs.
Even as there are limits to the role of monetary policy in boosting growth, the Fed is unlikely to put roadblocks to accommodation till GDP is back into positive growth and the labour market recovers meaningfully.
India would be pleased with the Fed minutes
What is significant from an Indian perspective is that Fed has promised it would first signal an end to balance sheet expansion before even considering hike in Fed rates. That means; at least till the middle of 2022, rate hikes are ruled out. For India, the accommodative policy can continue without worry about FPIs dumping Indian debt. Secondly, if inflation comes under control in India, it also opens the doors for the RBI to consider more rate cuts.
But the biggest positive takeaway for the Indian markets is on the liquidity front. Continued asset purchases mean liquidity will be abundant and ETF and passive flows should continue. For Indian markets, that has always been good news!