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Fed keeps policy loose despite brighter economic picture
Speedy vaccinations and another massive round of fiscal stimulus led the Fed to upgrade its forecasts for the U.S. economy. But it still forecasts a few more years of zero interest rates before policy starts to normalize again.
Bullish and dovish
The Federal Reserve’s Open Market Committee (FOMC) made no policy changes at its March meeting despite widespread agreement among economists – including those at the Fed – that the U.S. economy is about to take off like a rocket. The Fed’s statement emphasized the damage done by the pandemic, but acknowledged that “indicators of economic activity and employment have turned up recently.”
We also saw more optimism in the Fed’s updated forecasts for growth, inflation and employment. All of them moved higher, to varying degrees, for 2021 and beyond. Crucially, however, a solid majority of FOMC members still believe the soonest the Fed will have to raise interest rates is 2024. Despite considerably stronger growth than it expected just three months ago, the Fed’s reaction function remains extremely dovish.
Since the Fed’s last meeting in January, Congress has passed and the president has signed the American Rescue Plan Act, which provides another $1.9 trillion in stimulus, the bulk of which is directed at individual households. This action, along with the accelerating pace of vaccinations, clearly contributed to the Fed’s more bullish assessment of the economy this year.
In his press conference following the meeting, Chair Jay Powell was asked why, in the face of stronger growth, the Fed was not even considering adjusting its asset purchase program or raising interest rates. He replied that the Fed needs to not just project substantial progress toward its goals, but actually see that progress occur.
Markets viewed the overall result of the meeting as moderately dovish compared to expectations. Market-implied odds of an interest rate increase in 2022 and 2023 fell somewhat in afternoon trading, and the 10-year U.S. Treasury yield was little changed.
Why still so dovish?
This meeting taught us quite a bit about the Fed’s reaction function under what it has termed Flexible Average Inflation Targeting. This policy, adopted last year, was designed to create more symmetrical risks around the Fed’s 2% core PCE inflation target. In practice, it compels the Fed to be more tolerant of rising inflation after periods – like the one we’ve been in for the past year – in which inflation has been stubbornly low. The median forecast for core PCE inflation is now at or above 2% every year through 2023, yet only a small minority of members view that as likely to warrant even a single rate hike.
Consider that a little over a year ago, the U.S. unemployment rate was 3.5%, the labor force comprised roughly four million more people and inflation was still quite tame. The Fed sees no need to sound the alarm on inflation risks today, with unemployment at 6.2% and millions no longer looking for work for various reasons. Inflation has also been subdued despite sharply rising oil prices.
The Fed’s new forecasts suggest that even economic growth of 6.5% is unlikely to produce the type of inflation in the near term that will require an earlier liftoff in rates. That doesn’t mean the Fed is right, but it does tell us that the majority of the committee remains a) tolerant of inflation slightly above 2%; and b) under the impression that the U.S. is in a very deep economic hole and will be for some time.
Ignore the spring inflation blip
As we look ahead, the inflation story will get a bit more complicated. We’ll start to see significant acceleration year-over-year in the March and April data releases as the very weak readings from spring 2020, brought about by the COVID-19 mitigation efforts, roll out of the one-year sample. The Fed has been saying for months that it will ignore inflation increases that are due to “base effects,” and we encourage all investors to do the same.
Later this year, we may see a more economically significant rise in inflation as consumers switch their consumption preferences from goods to services and businesses attempt to return to their former capacities in the face of sharply rising demand. This could cause some relative price shifts in the near term, but, again, nothing that will trigger the Fed into action on rates or asset purchases. As capacity is restored, supply should catch up to demand, forestalling a genuine inflationary spiral.
Where do we go from here?
Long-term U.S. interest rates have undoubtedly risen faster than we – or, probably, the Fed – expected them to. But the U.S. economy and its equity market seem able to cope with higher rates, as long as the process is gradual and the Fed maintains its dovish posture. Much of the increase we’ve seen to date has been due to a normalization of inflation expectations, a phenomenon that can only happen once. If markets become concerned that the Fed will tighten policy prematurely, the U.S. 10-year Treasury rate could rise above its current 1.5% to 2.0% range. We doubt this will happen in 2021, however.
Investors concerned about inflation can address this risk while maintaining balanced asset allocations. Equities are historically a good inflation hedge, particularly when that inflation does not produce an immediate tightening response from the Fed. Real assets like farmland, timber or real estate can also hold up well, as they deliver income to investors that rises with the general level of prices. Floating rate notes, including loans, can also help income-sensitive investors cope with rising interest rates.
Federal Reserve Statement, March 2021.
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