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FOMC Guidance Sets New Tone for Future Rate Forecasting

November 09, 2020

By Jonathan Jackson, Catalyst Strategic Solutions Senior Advisor


The Federal Reserve Open Market Committee (FOMC) has been busy in 2020. After cutting the Fed Funds rate to a range of 0-0.25 percent in March, the FOMC implemented several new programs to support the economy and ensure the markets remained liquid in the midst of the COVID-19 pandemic. Wide ranging in objective, these programs included quantitative easing asset purchases, support for money market mutual funds and commercial paper markets, along with many others. As a result of these asset purchases and programs, the Fed’s balance sheet has increased by more than $3 trillion, to a staggering $7.2 trillion in total assets to date.

However, the FOMC recently made another pivotal announcement – a change that doesn’t acquire additional balance sheet cost but could have a substantial impact on the future path of interest rates. In late August, a new update to policy framework was introduced which included a major shift in strategy for potential rate hikes. In an effort to provide further clarity, the FOMC issued explicit guidance, reinstating its commitment to leaving rates unchanged until the new set of economic parameters is met.

Going forward, all three of the following criteria must now be established for the committee to increase rates:

  1. The economy reaches the FOMC’s assessment of maximum employment
  2. Inflation reaches two percent
  3. Inflation likely will moderately exceed two percent for some time

Let’s take a closer look at each of these requirements as defined by the FOMC:

1. Maximum employment

In the eyes of the Fed, what would it take for the economy to reach maximum employment? The unemployment rate plays a central role in this assessment, as Chairman Powell made it clear the committee would like it to fall back below four percent. The Chairman also expressed that maximum employment will be determined by more than just the unemployment rate. Other key factors will be used to assess this criteria, including the labor force participation rate, wage growth and income gains. Determining when the economy could reach maximum employment is somewhat unclear, so market participants will need to rely on future Fed communication to decipher the committee’s latest viewpoint on employment.

2. Two percent average inflation target

The explicit guidance on inflation is a little more discernible/straightforward. In past cycles, the FOMC increased rates when forecasts and models projected inflation would soon reach, and exceed, their inflation target. The result was that the two percent target inflation rate became a cap, instead of a target. The change in strategy means that now the Fed will only increase rates when inflation actually reaches two percent and is likely to moderately exceed two percent for some time.

3. Continuance of moderately increased inflation period above two percent

This criterion is as open-ended as it sounds. The phrase “moderately exceeds two percent for some time” leaves some gray area as to when the FOMC will actually hike rates. It is clear, though, that if this strategy remains in place, short term rates will remain at their current level of near zero percent until inflation reaches and remains at two percent.

What does this mean for credit unions?

The key takeaway is that we can expect, and should plan for, short-term rates to remain low for an extended period. The FOMC Dot Plot (as seen below) indicates individual FOMC Dot Plot on Interest Rate Forecastingparticipants’ judgment of the appropriate target range for the Fed Funds rate at the next three year-ends, as well as the long run projected rate. The dot plot – released in September – indicated that none of the 17 participants expected a higher Fed Funds rate in 2020 or 2021; only one participant expected a higher Fed Funds rate by the end of 2022; and four by the end of 2023. Credit unions should forecast low interest rates on investments and loans as they prepare their 2021 budget. Additionally, lower interest rates will likely keep the demand for mortgage loans high, which could create interest rate risk on the balance sheet. To avoid such a scenario, credit unions should actively assess the impact long-term real estate loans may have on their balance sheet risk profile. Catalyst Strategic Solutions’ team of experienced ALM and Advisory professionals are able to assist with this analysis and provide an expert level of insight to help you stay one step ahead.

For more information, or to request a thorough assessment of your balance sheet risk profile, contact us today.