Fed expects no hikes until 2023
At today’s quarterly meeting, the Fed released its latest ‘dot plot’. As widely expected, the committee’s median estimate continued to reflect no rate hike in 2021 or 2022 and two rate hikes for 2023. This puts the Fed’s rate projections narrowly below market pricing. There was, however, a wide range of views with five doves predicting no hikes in 2023, and two hawks predicting six hikes.
The Fed also revealed its quarterly economic forecasts, for instance updating its median PCE estimate to just above 2% in 2022 from 2% last quarter. It is notable that it does not anticipate raising rates next year despite the inflation overshoot given its new average inflation targeting framework. While some members of the Fed have revised up their rate estimates given the stronger economic backdrop, we view the center of the committee as being patient.
Fed sticks to ‘transitory’ inflation view
Chairman Jay Powell reiterated in the press conference, that the Fed sees the current run of above-target inflation figures as being distorted by transitory factors, particularly temporary supply chain disruptions and base effects. The Fed’s assessment matches our current view (see Instant Insights: Peak CPI?).
Taper talk will have to wait
Although rate hikes are some ways away, markets are looking for clues as to when the Fed will begin to ‘taper’ its asset purchases, taking its foot off the monetary easing accelerator.
As we expected, the Fed avoided any direct ‘taper talk’. Although, during the press conference, Chair Powell noted the committee was at the ‘talking about talking about it’ stage, discussing the framework around a future taper but with no formal guidance as to when to pull the trigger.
We suspect markets will have to wait until the Jackson Hole Summit in August before more formal discussions take place, which could lay the groundwork for an official tapering announcement by December, and actual tapering occurring over 2022.
Why wait so long before even slowing stimulus?
Importantly, even when the Fed eventually tapers its purchases, it will still be expanding its balance sheet, thereby keeping policy easy. We are potentially years from the Fed actually shrinking its balance sheet and actively tightening policy.
With the latest nominal CPI print at 5% and core inflation at its highest since the 1990s, it may seem perverse that the Fed is still aggressively easing policy, particularly amid a surging housing market and ahead of a summer reopening of the economy in which consumers appear to be rushing to spend the savings they accumulated under lockdown.
In our view, the Fed is intent on ensuring the recovery is as broad-based as possible. Although real GDP has now passed its pre-COVID peak, some areas still need to catch up (Figure 1).
Figure 1: The recovery has been uneven so far1
Secondly, the Fed also appears comfortable with ‘transitory’ inflation risks, particularly given years of undershoots and secular disinflationary trends (see The inflation debate is overheating).
Finally, the labor market is still far from returning to its pre-COVID strength, particularly within manufacturing and export-heavy sectors. Consumer spending tilting from services like travel, toward durable goods like home office furniture has been a factor.
Notably, over the next few months, we expect employment data will provide a clearer fundamental picture of factors constraining labor supply (like partially open schools and enhanced unemployment insurance). We anticipate significant improvement in the labor market which will potentially open the door to ‘taper talk’ at Jackson Hole.
The Fed’s expanding balance sheet will potentially continue to support financial assets
As the Fed’s balance sheet continues to expand (which will continue even once tapering eventually begins), we expect it to continue to offer support to financial markets. As the Fed purchases bonds to hold on its balance sheet, it effectively reduces the available supply of investible financial assets to other investors.
Since 2020, the Fed has expanded its balance sheet by $3.7trn. This is about $1.6trn higher than the net amount of bonds created in the Barclays Agg over the same period (Figure 2).
Figure 2: The Fed’s balance sheet has been growing faster than the Core bond market2
This ‘wall of cash’ created by the Fed has therefore largely been deployed in secondary markets, helping to keep corporate bond spreads tight and Treasury yields capped.
We believe that it could take over a year for the market to fully absorb this excess wall of cash. Therefore, in our view, the unprecedented magnitude of Fed policy will, all else equal, continue to be a yield suppressant and support the economic recovery well through 2022.
This adds to our view that ‘buying of dips’, i.e. taking advantage of yield back-ups and spread-widening events over the next few months could be a compelling strategy for fixed income investors.