On August 27, the Federal Open Market Committee (FOMC) updated its long-term goals and monetary policy strategy. The FOMC effectively indicated that it would prioritise the achievement and maintenance of full employment over preventing the personal consumption expenditures (PCE) price index inflation from exceeding 2%.
In a recent Credit Markets Review and Outlook, John Lonski, chief economist at Moody’s Capital Markets Research, writes that the FOMC intends to allow PCE price inflation to exceed its 2% target if price inflation had been averaging less than 2% over time. During the five-years-ended June 2020, the annual rate of PCE price index inflation averaged a mere 1.4%, which implies the FOMC might tolerate an annual rate of PCE price index of inflation well above 2% for an extended period.
However, the FOMC will not tolerate a deterioration of inflation expectations that puts unwanted upward pressure on Treasury bond yields and downward pressure on the dollar exchange rate. Nevertheless, the updated Fed policy strategy suggests that the stay by a now 0.125% midpoint for fed funds will be longer than anticipated.
Fed chairman Jerome Powell stated that the trade-off between price inflation and unemployment has improved considerably. Going forward, the FOMC will probably view a less-than-5% unemployment rate as less of a threat to long-term price stability.
Impact on bond yields
As inferred from the FOMC’s updated monetary policy strategy, increases by US Treasury bond yields in response to faster than expected price inflation and lower than anticipated unemployment rates will be more muted compared to the past, Lonski writes. However, an unwanted depreciation of the dollar may heighten the sensitivity of Treasury bond yields to faster than expected rates of growth for the PCE price index and payrolls.
The Outlook notes that, in view of how price deflation and slumps in profitability damage corporate credit quality, the Fed’s more relaxed approach to inflation targeting and increased tolerance of low unemployment rates ought to narrow corporate credit spreads. Notwithstanding a likely rise in longer term Treasury bond yields stemming from an increase in inflation expectations, corporate borrowing costs still might decline in response to a narrowing of the still historically wide spreads of medium- and speculative-grade corporate bonds and loans.
If the Fed can afford to push harder for economic growth and lower unemployment over the next five to 10 years, corporate debt ought to outperform US Treasury debt. In turn, the downside risks facing corporate borrowing activity will be lower than otherwise.
Fed chairman Jerome Powell mentioned that the US economy may grow no faster than 1.8% annually, on average, during the 2020s because of slower population growth, an ageing population, and relatively slow productivity growth. A slower underlying rate of economic growth implies both real interest rates and corporate earnings growth will be lower than otherwise.
A downshifting of corporate earnings growth may increase the attractiveness of debt in corporate capital structures. And, if corporate borrowers sense an acceleration of economic growth and inflation risks after the possibly senescent 2020s, corporations may show a stronger preference for long-term, fixed-rate debt, especially during the decade’s second half.
Benefits for corporate credit quality
On balance, Lonski says, a more pro-growth strategy on the part of the Federal Reserve would benefit corporate credit quality and help to prevent the downturns in rated corporate borrowing that occurred in the past. If companies are more convinced of a long stay by a relatively low federal funds rate, balance sheet leverage is likely to be greater than otherwise. Because of the now elevated levels of investment- and speculative-grade US$-denominated corporate bond issuance, the continuation of a 0.125% midpoint for fed funds will probably not immediately spur much additional bond issuance. Rather, a steady fed funds rate is more likely to lessen the risk of a deep drop by US$-denominated bond issuance. However, an extended stay by a 0.125% midpoint for fed funds favours a recovery by rated loan borrowing by high-yield issuers from the category’s now subpar pace.
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