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The Federal Open Market Committee (FOMC or Fed) made no changes to its monetary policy stance at its June 2020 meeting. But the first update to its forecast since December showed inflation and employment below their goals for at least 2 1/2 years. An outlook that bad for that long is a clear sign that policy is too tight.
The Fed announced that the federal funds rate would remain near 0 this year and most likely through the end of 2022. It also said that the pace of purchases of long-term assets (quantitative easing or QE) would continue “at least at the current pace” for now.
The Fed’s Summary of Economic Projections showed that unemployment is expected to remain at least 2 percentage points higher than the February 2020 level, and inflation would remain below its 2 percent target, through the end of 2022. Monetary policy should always aim to get the economy back on target within about three years. Either the Fed’s forecast is too pessimistic or its policy is too tight. Indeed, both may be true.
It is arguable that the Fed’s forecast is too pessimistic. It is possible that FOMC participants did not factor in a likely new fiscal package being negotiated in Congress. If fiscal policy and the Fed lending programs are able to prevent widespread bankruptcies and business closures, at least for medium-sized and larger firms that are not easily replaced, and if an effective vaccine for COVID-19 is distributed in 2021, it is possible that unemployment could drop much faster than the Fed projects in 2022.
However, those are big “ifs.” Worse outcomes are certainly possible. The May 2020 Survey of Professional Forecasters found that respondents perceive a 30 percent probability of the unemployment rate being less than 5 percent in 2022 and slightly more than a 30 percent probability of unemployment being more than 7 percent. That is an unusually large range of likely outcomes. Moreover, the dispersion across individual forecasters’ projections for the most likely level of unemployment four quarters ahead is the highest ever recorded by a large margin.[1] Some see a rapid recovery and others see the worst recession since the 1930s.
In the press conference after the June meeting, Chair Jerome Powell said repeatedly that “we would like to get back to that place [the 3.5 percent pre-pandemic unemployment rate].” Given the distance between that unemployment rate and the FOMC projection for the end of 2022, plus the possibility of even worse outcomes, this is the time to put the monetary pedal to the metal. If the economy surprises on the upside, the Fed will have plenty of time to recalibrate before problems emerge.
In practice that would mean setting the federal funds rate around –0.5 percent and expanding quantitative easing by enough to push the 10-year Treasury yield below zero. If these actions push the Treasury yield from the current level of 0.7 percent to around –0.3 percent, that would be equivalent to a cut in the policy rate of between 2 and 3 percentage points in normal times.[2] That is not an enormous policy easing, but it is substantial and worth having. The rest of the job of restoring inflation and employment is going to have to be taken up by fiscal policy going forward.
Notes
1. The dispersion measure is the difference between the 75th percentile of projections and the 25th percentile. For the unemployment rate, that is normally around 0.4 percentage points, rising close to 1 percentage point around the beginning of recessions. The May 2020 dispersion was 4 percentage points.
2. See my November 2019 policy brief with Christopher Collins for further discussion.
