The Federal Open Market Committee (FOMC) is expected to re-affirm its accommodative policy in the two-day meeting on July 27-28 and delay tapering, citing the spread of the Delta variant, persistent slack in the labor market, and excess capacity in the nation’s factories.
What is FOMC
The FOMC is a committee within the Federal Reserve System (Fed) overseeing open market operations (OMO). That is the main monetary policy instrument the central bank uses to set interest rates to accomplish its dual goal: steady inflation and high employment.
The Fed typically defines “steady inflation,” as an inflation rate of 2%. It defines “high employment” or “full employment” as a state of the U.S. economy when unemployment is low and close to the “natural rate,” but it has not explicitly stated an exact number for it.
High employment and the natural rate are moving targets. As a result, they vary over time, in response to changes in the American economy and labor market conditions. That’s why the FOMC holds regular meetings every five weeks, wherein its members go over scores of macroeconomic indicators to figure out how close or how far the economy is from high employment, and to set the course of monetary policy.
Indicators Monitored by FOMC
Two of the indicators FOMC monitors closely are the unemployment rate and non-farm payrolls, which measure the slack in the labor market.
Then there’s capacity utilization, which measures the slack capacity in the nation’s factories, meaning how much capacity is being used out of the total available capacity to produce finished products that are in demand.
A high slack in the labor market and plenty of excess capacity in the nation’s factories is an indication that the U.S. economy is operating below the Fed’s target of high employment. That means there’s plenty of room for accommodation (monetary easing), or taking actions to stimulate the economy, without the risk of such policy pushing inflation above the Fed’s target of 2%.
By contrast, low slack in the labor market and little excess capacity in the nation’s factories is an indication that the U.S. economy is overheating. In that case, it runs the risk of exceeding the Fed’s inflation target, meaning that the Fed must reverse course and tighten monetary policy.
Meanwhile, the Fed closely follows factors that affect the demand side of the economy, like the COVID-19 epidemic, which affects economic growth, and eventually impacts upon employment and inflation.
How OMO Works
Before the Great Recession, OMO was confined to the purchase and sale of assets with short maturity, allowing the Fed to control short-term interest rates. In the aftermath of the Great Recession, OMO was extended to the purchase and sale of long-maturity assets, allowing the Fed to control short-term and long-term rates.
The State of Monetary Policy Under the COVID-19 Pandemic
The Fed’s policy has been accommodative over the past 16 months, as the COVID-19 recession pushed the U.S. economy far below full employment and inflation stayed below 2%. That means the Fed has been adding liquidity into the economy by purchasing both short-term and long-term assets.
That has been bullish for Wall Street, as low short-term and long-term interest rates push investors into higher-risk assets like stocks, high yield debt, and cryptocurrencies.
Yet as the U.S. economy has been recovering from the COVID-19 recession, and some inflation numbers are running at 5%, the FOMC may have to change its policy from monetary easing to monetary tightening. That means tapering off the purchase of short-term and long-term assets and higher interest rates.
Here’s a quote from the June FOMC minutes: “In their discussion of monetary policy for this meeting, members agreed that progress on vaccinations had reduced the spread of COVID-19 in the United States. They noted that amid progress and strong policy support, indicators of economic activity and employment had strengthened. Although the sectors most adversely affected by the pandemic remained weak, they had shown improvement. In addition, inflation had risen, largely reflecting transitory factors.”
Wall Street isn’t happy with this prospect, as higher interest rates could make high-risk assets less appealing to investors, and the amount and percentage of assets that qualify as high-risk have exploded in recent decades.
On the other hand, this prospect is doubtful at this point. Instead, the Delta variant has revived fears of another wave of lock-down measures, which could slow down the pace of economic recovery and ease fears of inflation spinning out of control.
Here’s another quote from the June FOMC minutes. “Members also agreed that the path of the economy would depend significantly on the course of the virus. Progress on vaccinations would likely continue to reduce the effects of the public health crisis on the economy, but risks to the economic outlook remained.”
Then there’s the continuing slack in the labor market. The unemployment rate stands at 5.9%, well above the 4.2% that the Fed considers the natural unemployment rate.
Additionally, there’s capacity utilization, which stands at 76%, well below 84%, which is considered full capacity.
The bottom line: the Fed has plenty of reasons to keep monetary policy accommodative and postpone tapering.
Summary and Conclusions
In its July meeting, the FOMC is expected to continue its accommodative policy of low interest rates and postpone tapering, due to the spread of the Delta variant and the continuing slack of the economy. That could easily change in the following meetings if those problems ease and the U.S. economy begins to overheat.