First Fomc Meeting of 2021: What to Learn From The Fed's Mistakes

See why the Fed has limited room for interest rate cuts in next week's FOMC meeting to fight the recession - and what you can do about it.
By Richard Barrington
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The Federal Reserve Board will be facing tough challenges next week when it holds the first Federal Open Market Committee (FOMC) meeting of 2021. To make matters worse, it has few options for how to address the challenges.

The Fed's predicament holds important lessons for consumers trying to make decisions about how to handle their own finances in the year ahead.

Fortunately, unlike the Fed, consumers have options for how to deal with the recession and other financial complications that stem from the COVID pandemic. However, they'll need to be decisive when making decisions in this environment.

The Fed's current situation is an example of the price to be paid for hesitating when circumstances call for action. The difficulties the Fed will grapple with next week are due to the pandemic, in part, but also due to the policies the Fed has pursued in the years leading up to the pandemic.

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Fed Unprepared for This Recession

No one can blame Fed Chair Jerome Powell and his colleagues for being surprised by the pandemic. What left them especially unprepared, though, was the policy course the Fed had charted in the years leading up to 2020.

Around the end of every calendar quarter, the Federal Reserve releases economic projections for what it expects to happen in the years ahead. The projections released at the end of 2019 show just what a surprise 2020 turned out to be.

Unemployment and the federal funds rate

Perhaps the most telling example of how 2020 turned out differently than the Fed expected is the unemployment rate. At the end of 2019, the Fed projected that the U.S. unemployment rate would be 3.5% at the end of 2020. Instead, unemployment was almost twice as high, averaging 6.8% in the fourth quarter of 2020.

Normally, such a jump in unemployment would prompt steep interest rate cuts by the Fed. In this case, though, the Fed had left itself little room to cut rates.

Then and now: Comparing Fed policy decisions

The Federal Reserve interest rate entered 2020 at 1.6%. That is well below where the fed rate has been historically. When the pandemic hit, the Fed did take action by cutting rates - but they were starting out at such a low level that there was little room for them to move.

The fed rate ended 2020 at 0.09%, a drop of 1.51% from the start of the year. Contrast that with the response to the financial crisis and the Great Recession when the Fed was able to cut rates by about 5% in late 2007 and 2008.

This time, the response was limited by what the Fed did in the decade between the Great Recession and the pandemic. Although there were a handful of fed rate hikes from 2015 to 2017, overall, the Fed was slow to raise rates when the economy was growing.

Lessons: Missed Opportunities Have Consequences

The economic expansion from June of 2009 through February of 2020 was the longest on record. Economic projections from the end of 2019 show the FOMC expected the good times to continue for at least another three years.

Even so, despite this unusually long run of good luck, the Fed missed the opportunity to restore interest rates to more normal levels. That's why it was left with little room to move when the 2020 recession hit.

The blame for this should not all fall on Powell's shoulders. Much of the FOMC's hesitance to raise rates took place when his predecessor, Janet Yellen, was Fed Chair. However, Powell was a member of the FOMC before he rose to Chair, so he did take part in those decisions.

The lesson for consumers facing financial decisions is that you have to be prepared to act before conditions change. If you wait for trouble, it may be too late.

What the Fed Faces Now

The immediate challenge facing the Fed is a very bad job market:

  • December was the first month for net job losses since April, indicating that the partial bounce back in the economy is weakening.
  • 2020 was the first year for net job losses since 2009.
  • Based on Bureau of Labor Statistics data going back to 1939, 2020 was the worst year for job losses on record.
  • The current unemployment rate may be even worse than it seems because, last year, labor force participation plunged to its lowest rate since the mid-1970s. This suggests that many people have simply given up looking for work and thus are not included in the unemployment rate.

Normally, such a weak job market would call for interest rate cuts; but with the fed funds rate already near zero, they have little room to fall.

Instead, the Fed is trying to do the next best thing to cutting rates, which is to indicate that rates will remain low for a long time. The latest round of FOMC economic projections indicate that rates will stay near zero through at least the end of 2023.

However, if 2020 proved anything, it's that things don't always work out as planned.

What could really upset the apple cart in 2021 is if inflation continues to pick up steam. While the Consumer Price Index rose by a mild 1.4% for all of 2020, in the second half it rose at a more threatening annualized rate of over 3.5%.

A continued surge in inflation could force interest rates higher, and leave some consumers and investors vulnerable.

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Decisions for Consumers and Investors

With the threat of rising inflation forcing interest rates higher, along with the more general threat of unexpected changes to current conditions, here are some things consumers and investors should think about as the FOMC meets next week:

  • Credit remains cheap - but challenging
    Car loan rates, credit card rates, personal loan rates and mortgage rates all ended 2020 lower than when they began the year. That means now is a good time to borrow, with a couple cautions:
    • In a weak job market, be sure of your job security before you take on additional financial obligations.
    • Also, be sure to lock in a fixed interest rate - rates are unlikely to go much lower than they are today, but they could certainly go a lot higher.
  • Savings account rates demand action
    The latest MoneyRates.com America's Best Rates survey found that, by the end of 2020, the average savings account was producing just a third of the interest it was producing when the year began. Unless you want to settle for earning much less in 2021, you should switch to a higher-yielding savings account, with online accounts offering the best opportunity to raise your rate.
  • Don't get complacent about the stock market
    Despite all the challenges of 2020, the U.S. stock market had a strong year. However, the economy remains weak and much of the market would be vulnerable if interest rates were to rise.
    This is a good time to revisit your asset allocation. Rebalance your stock position to where it was before last year's gains and assess whether you are still comfortable taking that level of risk.

The Fed painted itself into its current policy corner by not acting while it had the chance. Consumers and investors should take that as a reminder not to delay their financial decisions.


Previous Federal Reserve Board Updates articles:

FOMC Date2020 FOMC Meeting Update Articles
12/10/2020Next FOMC Meeting: High Drama, Low Interest Rates
10/28/2020FOMC Meeting Preview: What to Expect after the Election
09/09/2020Fed Meeting Preview: Loosening the Reins on Inflation
07/23/2020Next Federal Reserve Meeting: Consumers Have More Options Than the Fed
06/04/2020Will the Next Fed Meeting Lead to Negative Interest Rates?
04/23/2020The Federal Reserve in Crisis: What's Next?
03/12/2020Next Fed Meeting Won't Solve Global Economic Crisis, But Here's What Consumers Can Do
01/22/2020January 2020 Fed Meeting - More Than Meets the Eye?

 

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