At perhaps the most anticipated FOMC meeting since last spring, the Fed significantly revised its economic projections to reflect the $1.9bn stimulus package signed by President Biden last week and the accelerating pace of US COVID-19 vaccinations.
After the US economy performed significantly better than feared last year, the Fed now forecasts GDP growth at 6.5% this year (from 4.2% previously), unemployment below 4% by the end of 2022 and perhaps most notably, core PCE at or above its 2% target over the next three years.
Figure 1: The Fed’s GDP, inflation and unemployment expectations continue to improve1
No change in the median ‘dot plot’
The Fed’s closely watched dot plot was unchanged, reflecting a median expectation of no policy rate hikes through to 2023.
This is consistent with its revised policy of targeting an average inflation level of 2% rather than an absolute level, implying a measure of tolerance for above-target inflation before raising rates.
Notably, there were still seven FOMC members that favored a rate hike in 2023, up slightly from five previously. This is perhaps significant enough to raise the question about whether an upside surprise in actual inflation at 2.3% or beyond could pull rate hikes forward.
How much accommodation is too much?
One thing that has not significantly changed is the Fed’s continued stance of providing abundant monetary accommodation.
However, markets are grappling with the fundamental question of whether an economy that has just passed a major fiscal stimulus requires less monetary policy accommodation. We expect the debate, about how much combined accommodation is too much, to continue for months.
The inflation debate will overheat
A faster recovery than forecast by the Fed that pushes inflation higher could challenge the Fed’s position next year. Our own GDP forecast is about 0.6 percentage points higher than the Fed’s in 2021. However, while inflation risks have undoubtedly risen, there remains a sizable output gap and secular disinflationary trends that have yet to be overcome, making a sustained inflation overshoot far from a sure thing.
Still too early to taper
Our view remains that the Fed may begin tapering its QE purchases by the end of this year, meaning its balance sheet expansion could be stopped by the end of 2022.
In our view, this still would not leave the Fed in a position to raise interest rates until mid-2023, and it will require core PCE to run above the Fed’s 2% target in a sustained fashion.
More curve-steepening to come?
We see scope for US Treasury yields to continue to move somewhat higher if the economy develops as expected. Importantly, however, we expect this move to be driven, not by the fear of a Fed policy error with respect to pre-emptive tightening, but because the economic recovery has been exceeding virtually all expectations.
While higher rates can cause near-term indigestion, in our view this is ultimately a positive development for investors, particularly in credit assets.