What Options Does the Fed Have Now?

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As the reality of the COVID situation in March set in, the markets took a steep nosedive.

It didn’t halt until the Fed held an extraordinary meeting to announce unprecedented measures to help the economy. Many argue that it’s thanks to the Fed that the market crisis wasn’t worse.

But, now the Fed is in an open-ended asset purchasing program that has led to a never-before-seen expansion in the balance sheet. Not even in the worst part of the Great Financial Crisis did anyone expect the Fed to feel the need to take such drastic action.

And it’s not a tenable position for the Fed. Their current policy can’t continue forever, and now the debate is just when the changes will be made.

What To Do?

Equity markets have recovered healthily in the last couple of months.

Now, we’ve started getting encouraging economic data as retailers reopen. Evidently we are not out of the woods, yet. And the data for June is largely going to be a determinant of whether we can expect a recovery, or if the economy is too scared and will need more time to recover.

It’s time to get ahead of events and think about what the Fed could do in the near future.

There are still policy options in case of a worsening scenario, and there are other concerns in case of an improving scenario. Some of the key ones are as follows.

Negative Rates & Yield Control

The Fed has been notably pessimistic about economic recovery, even in its most recent meeting. Part of this is explained by the need to justify continuation of their policy, It’s also because they don’t want to get caught by any negative surprises.

Too much QE is seen as a better alternative to too little.

Should the Fed decide that the economy needs more stimulus, the two options being considered are:

Negative interest rates

As used (with dubious success) by the BOJ and SNB, we would expect this to weaken the dollar and prop up markets. However, most FOMC members have shown to be quite opposed to this option.

YCC

Yield Curve Control has had some positive comments from FOMC members. This is where the Fed buys more long-term bonds in order to depress longer-term interest rates (the tail of the curve).

Notably, in this latest version of QE, the Fed has been buying less at the tail of the curve than in prior stimulus programs. This option is seen as less likely to cause a recession.

Another Taper Tantrum

As the economy recovers, eventually the Fed is going to have to put a limit to its asset purchases.

It is already starting to slow the pace but hasn’t given an official number. Some analysts say the balance sheet could expand to up to $10T, from the over $7.1T currently.

The last time the Fed warned of an impending tapering of the money printer, it riled up markets considerably, and they are likely to try to avoid that with cautious language in an upcoming meeting.

By then, Q2 will be over, and we will have better data to judge.

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