Fed likely to keep rate near zero for years

Paul Davidson

Despite a stunningly strong May jobs report last week, the Federal Reserve on Wednesday is expected to maintain its dour economic outlook amid the coronavirus pandemic and signal that it’s likely to keep its key interest rate near zero at least through 2022.

The Fed’s cautious approach would serve as a counterpoint to Senate Republicans, who indicated they’re in no rush to pass another massive stimulus after the blockbuster employment news revealed an economy that may be rebounding sooner than anticipated from the depths of the health crisis.

While acknowledging the improvement in U.S. payrolls, “We think (the Fed) will retain its overall very downbeat tone, continuing to note ‘considerable risks’ to the outlook,” says economist Michael Feroli of JPMorgan Chase.

“There’s still tremendous uncertainty,” says economist Kathy Bostjancic of Oxford Economics.

A Fed vow to keep doing whatever it takes to help dig the economy and labor market out of a historically deep hole could bolster a stock market rally that gained further momentum after Friday’s jobs data was released.

Following a two-day meeting that begins Tuesday, the central bank is scheduled to provide its first forecasts for the economy and interest rates since December. Fed officials declined to update their projections when the crisis began in March, citing unusual uncertainty about the outlook.

Goldman Sachs economist David Mericle reckons the Fed’s policymaking committee will predict the economy will contract 4% this year, followed by strong gains of 5% and 3.5% the next two years, based on officials’ median estimate. But the central bank, he believes, will forecast an unemployment rate that remains elevated, at 10% by December and 7.5% at the end of 2021. The jobless rate was at a 50year low of 3.5% in February.

The weak economy is spelling inflation that’s even more meager than precrisis levels. The Fed likely will foresee its preferred measure of consumer prices, which strips out volatile food and energy costs, rising 1% this year and 1.4% in 2021, Mericle says, well below its 2% target.

High unemployment and feeble inflation give the central bank more room to keep its benchmark shortterm interest rate at rock-bottom levels. The Fed’s median estimate will likely project a federal funds rate that stays near zero at least through 2022, Mericle says. But analysts will be closely watching to see if a significant group of policymakers envisions an earlier hike in rates.

In its postmeeting statement, the Fed is expected to reiterate that it will keep rates near zero “until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.”

By September, however, economists expect the central bank to provide more explicit guidance. Mericle thinks the Fed will promise to keep rates low until the economy reaches full employment – roughly a jobless rate of about 4.5% – and 2% inflation.

Bostjancic believes the Fed instead will agree to keep rates near zero for a certain time period, such as three years. At the same time, she says, the Fed will likely announce that it’s buying enough three-year Treasury bonds to ensure their rates remain historically low until they mature – a strategy known as yield curve control. Such a tactic could prevent Treasury yields from rising despite the Fed’s near-zero rates now that Congress has run up the nation’s debt with trillions of dollars in coronavirus relief.

Besides lowering rates to near zero, the Fed also has purchased about $2.2 trillion in Treasury bonds and mortgage-backed securities to thaw financial markets that had frozen out of fear. The Fed said it would buy as much as needed. But Morgan Stanley thinks the Fed on Wednesday could set a fixed amount, such as $80 billion a month in Treasuries and $50 billion monthly in mortgage bonds.

The Fed has responded aggressively to the steepest recession in U.S. history. While the downturn is likely to be brief, it’s expected to leave lasting damage.

In mid-March, states issued stayat-home orders and told nonessential businesses to shut down to contain the spread of the virus. The economy contracted at a 5% annual rate in the first quarter and is expected to plummet as much as a record 40% in the AprilJune period. Employers shed more than 22 million jobs in March and April, wiping out all the gain since the great recession of 2007-09.

But in recent weeks, states have started allowing businesses to reopen in phases. Last week, the Labor Department said the economy unexpectedly added 2.5 million jobs in May and the unemployment rate fell to 13.3% from 14.7%. Economic output is expected to rebound strongly in the third quarter as more states continue to ease restrictions.

But while the rebound occurred earlier than anticipated, many businesses have shut down permanently and consumers are unlikely to return to restaurants, shops and other outlets in large numbers until a vaccine is available, possibly by mid-next year. Health officials also worry about a second wave of the virus that could force states to close businesses again. By year’s end, Oxford expects the economy to recover just 60% of the jobs lost in the spring.