Going into the December Federal Open Market Committee meeting, there were few expectations of a meaningful policy change. Tightening policy via hikes or tapering asset purchases is not going to happen until inflation materially rises above 2%. There was a minority who believed the Federal Reserve may increase its asset purchases or initiate some sort of "yield curve control" due to the virus' spread getting worse since the last meeting, while the federal government has been unable to agree on a stimulus package.

The Fed did provide some clarity on its asset purchases by saying it would continue to buy $120 billion in bonds per month "until substantial further progress has been made toward the Committee's maximum employment and price stability goals." The FOMC also kept interest rates unchanged at zero percent, while slightly upping forecasts for growth and employment in light of the economy's resilience.

Financial Stability Risks

In terms of its current toolkit, the Fed's policies are at max-dovish levels. And through forward guidance, it's been clear that this policy stance will continue until the situation meaningfully improves. Many attribute the current frothiness in the markets to the Fed's stance. However, the Fed has clearly decided that the risks of financial bubbles are worth swallowing. For the stock market, the circumstance is ideal.

Weakness in the economy means that monetary policy will remain supportive. However, the economy is not weak enough that it's leading to earnings decline. Instead, earnings in Q3 are only off 3% from last year. In part, it's due to companies cutting costs and taking advantage of low rates. Another factor is that goods-producing parts of the economy have remained resilient which are comprised of public companies, while service-based businesses which are predominantly small businesses have seen the biggest impact from the coronavirus.

Outlook

Since the Fed initiated its aggressive policy in the Spring, monetary policy has gotten looser. This is because the economy has significantly improved, yet policy remains unchanged. One way of looking at this is the difference between the 10-year yield and the Fed funds rate. This has gone from 0.5% in the spring to 0.9% today.

It's going to be very interesting to see how the Fed reacts in the coming months if the economy continues to improve. We have a couple of rough months near-term. However, under-the-surface, we are seeing a strong recovery in manufacturing. At some point, travel-sectors will return providing a cyclical boost. On top of that, housing and technology remain in growth mode.

This is going to be what Fed observers will be paying attention to - how hot will the Fed run the economy. If we get a blip higher in inflation will the Fed immediately begin to tighten?