Fed outlook dims but approach remains the same… for now

A perspective from E*TRADE Capital Management, LLC 07/30/20

The Federal Reserve reaffirmed its commitment to maintaining near-zero interest rates through at least 2022 during its latest policy meeting on Wednesday, July 29. Officials indicated they were weighing policy changes as they review the economic outlook, but held off on providing additional stimulus or forward guidance.

The meeting came at a critical juncture for the US economy: A (relatively speaking) strong rebound in business activity in the spring and early summer, followed by a resurgence of coronavirus infections in recent weeks that has delayed and even rolled back reopening progress, raising concerns of a more prolonged recovery.

So, what’s transpired since the Fed’s last meeting and what factors could potentially weigh on future policy decisions? Let’s break it down.

US fed funds target rate

FactSet Research Systems, July 29, 2020

The market is up… but so are virus cases

Since the Fed last convened in early June, the stock market has erased its losses from its February–March plummet and tipped into positive territory for the year. This comes despite another wave of outbreaks in the Sunbelt that has forced the reclosure of some bars, restaurants, and retail shops, potentially spelling trouble for hard-hit industries such as hospitality, entertainment, and travel if consumers don’t feel comfortable gathering in crowds.

Although investors may not be deterred by the surge in virus cases, the stock market is less of a focus for the Fed than the economy—and while the two are related, they are far from the same. When it comes to the economy, the central bank’s mandates are employment and inflation, and right now, it has its hands full on both fronts.

Employment and inflation in focus

A second wave poses additional risks to the labor market, which has recovered a third of the jobs lost during the height of lockdown.1 New claims for state unemployment benefits remain persistently high, topping one million for 19 straight weeks, while continuing claims (the number of people requesting an extension of jobless benefits) have hovered upwards of 15 million.2 What’s more, the latest data showed an uptick in new claims for the first time since March, a sign the job gains in May and June may be fading.

Meanwhile, although inflation is currently low, the longer-term concern is that it won’t stay that way in the face of the unprecedented monetary stimulus the Fed has unleashed to fight the coronavirus. Since the Fed slashed rates to zero in March, the dollar has fallen close to 9%, while gold has surged to all-time highs—both developments seen by some as warning signs of a potentially larger devaluation of the US currency and rampant inflation.3 

What’s the central bank saying?

The Fed isn’t likely to adjust its “all-in” stance any time soon. In fact, it extended its various lending programs through the end of the year, doubling down on its pledge to help support the economy until it’s firmly on its feet.

It acknowledged the current state of the environment in its post-meeting statement, saying, “Following sharp declines, economic activity and employment have picked up somewhat in recent months but remain well below their levels at the beginning of the year.”4

Fed Chairman Jerome Powell has cautioned that the path of recovery remains in limbo and depends largely on curbing the spread of the virus.

Looking ahead

The Fed’s July meeting announcement came amid renewed congressional negotiations over another round of fiscal stimulus—something for which Mr. Powell has advocated, and which could be especially important if the next jobs report (due out August 7) shows more cracks in the labor market recovery.

In addition to employment data, the central bank will also weigh second-quarter GDP, which fell by a historic 32.9%, to help gauge the trajectory of the economy. (For reference, the worst decline during the financial crisis was an 8.4% GDP drop in the fourth quarter of 2008.5)

While additional details from the July meeting won’t be released for a few weeks, minutes from the June meeting showed the committee was debating adjustments to monetary policy as economic needs evolve. Here are key topics Fed observers may be watching in future meetings:

  • Forward guidance: Investors may increasingly look to the Fed to strengthen guidance around interest rates and include thresholds for inflation and/or unemployment. For example, in late 2012, the Fed said it would keep rates at zero until the unemployment rate fell to 6.5% or inflation hit 2.5%.6
  • Asset purchases: The Fed’s balance sheet reached $7 trillion in June, up from $4.2 trillion in February, but its purchases have since slowed.7 The Fed’s outlook on asset purchases may be an indicator of whether it’s transitioning out of “crisis mode,” or potentially preparing to put out more fires.
  • Long-term rates: The central bank could set a target for longer-term interest rates and conduct bond purchases aimed at lowering longer-term borrowing costs to stimulate economic activity (also known as yield curve control).

The Federal Open Market Committee is next scheduled to meet September 15–16. Until then, investors are wise to stay the course and keep investing decisions focused on individual timelines, long-term goals, and risk tolerance.

  1. The Washington Post, “The U.S. economy added 4.8 million jobs in June, but fierce new headwinds have emerged,” 7/2/20, https://www.washingtonpost.com/business/2020/07/02/june-2020-jobs-report/?arc404=true&utm_source=morning_brew
  2. US Department of Labor, as of July 30, 2020.
  3. CNBC, “Dollar move signals new era of weakness for currency, as gold gains,” 7/27/20, https://www.cnbc.com/2020/07/27/dollar-hits-perfect-storm-as-gold-and-stocks-rise.html
  4. CNBC, “Fed holds rates steady, says economic growth is ‘well below’ pre-pandemic level,” 7/29/20, https://www.cnbc.com/2020/07/29/fed-meeting-decision-interest-rates.html
  5. CNBC, “U.S. second-quarter GDP plunged by a record 32.9%, vs 34.7% expected,” 7/30/20, https://www.cnbc.com/2020/07/30/us-gdp-q2-2020-first-reading.html
  6. MarketWatch, “Most Fed officials at June meeting agreed on need to clarify what could cause them to move interest rates off zero,” 7/1/20, https://www.marketwatch.com/story/most-fed-officials-at-june-meeting-agreed-on-need-to-clarify-what-could-cause-them-to-move-interest-rates-off-zero-2020-07-01
  7. The Wall Street Journal, “Why Growth in the Fed’s Asset Portfolio Has Paused,” 7/26/20, https://www.wsj.com/articles/why-growth-in-the-feds-asset-portfolio-has-paused-11595772001

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