MNI EXCLUSIVE: Covid 'Second Wave' Complicates Fed's QE Plan

--Worsening Credit Conditions May Reduce Urgency Of Forward Guidance

By Pedro Nicolaci da Costa and Jean Yung

     WASHINGTON (MNI) - Renewed concern about the U.S. economy amid a resurgence

in Covid-19 infections may complicate the Federal Reserve's plans to clarify the

likely path for interest rates and bond buys by the autumn, according to MNI

interviews with current and former top policymakers.

     Markets widely expect the Fed to make a major announcement by September

that would mark a transition from credit policy to outright monetary stimulus in

the form of forward guidance and asset purchases. The Fed could build forward

guidance into a revised policy framework, former Fed Board research director

David Wilcox told MNI.

     But as the second wave of Covid hits an economy left more fragile by the

first shock, current and former Fed officials are increasingly expecting credit

conditions to worsen in the next couple of months, prompting the Fed to extend

or expand its credit facilities, and reducing the urgency of providing future

assurances that interest rates will stay low.

     "This is no time for forward guidance, yield curve control, all that stuff

-- that's for later," ex-Fed governor Jeremy Stein, now chair of Harvard

University's economics department, told MNI. Most of the Fed's emergency credit

facilities are set to expire by September, and the FOMC is expected to give

details on the conditions that must be met before monetary stimulus is unwound.

     "The problem is in all these credit facilities -- and so far none of them

have gotten any action," Stein said. That could change, he added, as companies

and households feel the strain of a more prolonged recession.

     --DEFAULTS LOOMING

     The Fed has argued that low usage of its facilities is in part because

their very existence has eased some concerns about liquidity, but sources say

officials are still on watch for new potential flare-ups in specific corners of

the credit markets.

     "The potential for consumer default and commercial and industrial loan

defaults is high," Stein said. San Francisco Fed President Mary Daly and

Richmond Fed President Thomas Barkin also told a NABE webinar Tuesday they were

worried about potential credit troubles in energy and commercial real estate.

     Karen Dynan, a former Fed staffer and ex-White House economist under

President Barack Obama, told MNI the Fed would not hesitate "to push further on

the liquidity facilities" if credit conditions deteriorate in coming months.

     --MORE CLARITY

     Speaking exclusively with MNI Tuesday, Dallas Fed President Robert Kaplan

said he wants more clarity on the outlook before adding specific forward

guidance to the array of tools already propping up markets and the economy. "I

want to turn over a few more cards and see how the economy unfolds before being

prepared to say more about that," he said on guidance.

     Central bank forward guidance is typically deployed to dissuade markets

during a period of economic recovery. But if the economy is still heading south

in a couple of months, the Fed might find it harder to communicate future policy

in a convincing way.

     One way to do so might be to set a hard target for how high inflation would

need to go before the Fed raises interest rates or slows its asset purchases.

But, even then, it is unclear how much market impact forward guidance would have

in terms of lowering borrowing costs. Markets are already pricing in zero

interest rates as far as the eye can see.

     "Forward guidance can only stimulate the economy if you're correcting a

misimpression on the part of the market, where the market believes you're

raising rates when you won't be," former Fed Board economist Bill Nelson told

MNI. "If markets understand what you're going to do, there's no correction to

fix. And the committee will only go so far to tie the hands of a future

committee."

     --FRAMEWORK TIE-IN

     What investors really care about is the likely maximum size of the Fed's

balance sheet. On that front, officials are nowhere near ready to offer even

ballpark estimates.

     But former Fed Board research director Wilcox says the FOMC can strengthen

its ability to fight the recession by committing to keeping rates near zero and

purchasing high volumes of longer-term assets until inflation runs at 2% or

higher over a 12-month period and the labor market recovers.

     According to rough calculations by Wilcox and former Fed Board deputy

director David Reifschneider, staying on the current pace of buying USD80

billion of Treasuries and MBS per month would likely "replace a meaningful

proportion of the Fed's stimulative capacity lost as a consequence of not being

able to cut the rate further" -- without overwhelming the market or blowing up

the balance sheet, Wilcox told MNI.

     The Fed could build such a promise into its soon-to-be-finalized policy

framework review, as officials already seem to be leaning toward so-called

"outcome-based" forward guidance, Wilcox said.

     "The whole point of the longer run policy framework they're trying to build

is that it should be robust to changing economic circumstances. So merely

because today's circumstances are evolving is no reason to delay it or

accelerate the framework," he said.

--MNI Washington Bureau; +1 202 371 2121; email: pedro.dacosta@marketnews.com

--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com

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