Fed Keeps Rates Unchanged as Taper Talk Begins to Materialize

The Federal Open Market Committee (FOMC) stressed this week that economic indicators have improved and that employment in particular has shown sustained recovery, with vaccinations continuing across the country as the economy recovers from COVID-19. As Federal Reserve Chairman Jay Powell highlighted during his press conference, employment rose by 850,000 jobs in June, while the unemployment rate sits at 5.9%. Furthermore, household spending and business investment have continued to accelerate rapidly. The FOMC announced that it would keep the target range for the federal funds rate between 0 and 0.25% and continue to increase its Treasury and mortgage-backed securities holdings at the same monthly pace as the central bank continues to keep macroeconomic conditions accommodative for households and businesses. The Fed left the interest rate paid on reserve balances and the overnight reverse repo rate unchanged at 0.15 percent and 0.05 percent respectively to further support the functioning of broader money markets.

While these developments are a continuation of the status quo, the FOMC announced one major change – the establishment of two new repo facilities. As the Fed explained in its official statement, it will move forward with “the establishment of two standing repurchasing agreement (repo) facilities – a domestic standing repo facility (SRF) and a repo facility for foreign and international monetary authorities (FIMA repo facility).” These new provisions will aim to “serve as backstops in money markets to support the effective implementation of monetary policy and smooth market functioning.” The SRF will “conduct daily overnight repo operations against Treasury securities, agency debt securities, and agency mortgage-backed securities.” A standing repo facility would also allow banks to convert their Treasury holdings to reserves at the Fed’s specified rate. This serves two major functions: allow banks to more effectively respond to possible stress scenarios within money markets while simultaneously shrinking the size of the Fed’s balance sheet.

Mercatus Center economist Christopher Russo explains the significance of the central bank’s creation of the SRF on Wednesday: “The Fed uses repo to provide dollar loans to financial institutions in times of stress. Because they are overnight and collateralized by Treasuries, these loans are risk free. By specifically designating the activities as ‘standing facilities,’ market participants now know that dollar liquidity will always be available in a crisis like September 2019 or March 2020, with loan terms known in advance. This knowledge will improve monetary policy and market functioning even when the facility is not used, which I expect will be most of the time.”

Meanwhile, the Fed’s newly established FIMA repo facility will “enter into overnight repurchase agreements as needed with foreign institutions against their holdings of Treasury securities maintained in custody at the Federal Reserve Bank of New York.” The aim of this second facility will be to create temporary liquidity while helping “address pressures in global dollar funding markets” that could adversely affect domestic financial market conditions.

In addition to establishing these new facilities, the FOMC tweaked its forward guidance on asset purchases. The committee noted that the economy has made significant but incomplete progress toward the Fed’s goals of maximum employment and price stability. This shift in language raises questions about when the central bank plans to finally “taper” or scale back their asset purchases and subsequently raise interest rates. As the inflation rate continues to rise, some wonder whether this change in language is an indicator that the Fed expects the recovery to be achieved sooner than expected. Despite this, Powell stressed during his press conference that the labor market is still recovering, and that the committee will be sure to provide the necessary clarity and advance warning when they decide to wind down asset purchases and eventually raise rates.

Some observers are concerned whether recent price increases should still be considered transitory or if it reflects a new pattern of sustained inflation. In response, Powell remained steadfast, arguing that inflation is still likely to be transitory, as he adopted a reassuring tone during Wednesday’s press conference. He reiterated that inflation will most likely remain high in the short term, but mainly because of supply bottlenecks, price surges within isolated goods categories, and reopening economic sectors that were most affected by the pandemic. Although Powell didn’t offer a specific timeline for when the Fed expects the pace of inflation to slow, he explained that the Fed expects these price increases to abate over time, while providing reassurances that the central bank would do everything in its power to adjust the stance of policy to remain in line with its target of 2% inflation on average over time.