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Dovish Fed in an awkward position as inflation picks up

Brian Nick
Chief Investment Strategist
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Since its last meeting in April, the Fed has been greeted by a wave of hotter-than-expected inflation reports. As a result, its median forecasts for both inflation and interest rates in the coming years have risen. Even so, no imminent policy changes seem likely.

What happened?

The June meeting of the U.S. Federal Reserve’s Open Market Committee (FOMC) attracted more attention than most because of the events leading up to it. Since the Fed last met in April, U.S. inflation data has quickly accelerated while job creation has been disappointing. The U.S. central bank has a difficult choice to make: keep policy extremely easy until unemployment falls further or tighten policy to keep inflation under wraps.

For now, the Fed has decided squarely on the first option. It is clear that the committee believes the recent increase in inflation is both transitory and – up to a point – desirable. Even so, the median FOMC member now expects rate hikes to begin in 2023, a significant shift forward from the last set of forecasts in March.

The Fed’s statement notably did not reference any change in thinking regarding its current asset purchase program. Pressed on this topic in his post-meeting session with reporters, Chair Jay Powell said that the “substantial further progress” the economy would need to demonstrate before the committee would reduce its pace of asset purchases has not been achieved. He added that the committee would continue to assess the appropriateness of those purchases at upcoming meetings. We expect the Fed to announce its intention to taper purchases sometime this fall, before beginning to reduce the purchases in the first quarter of 2022.

Yeah, about that 2% inflation target...

The Fed’s median forecasts for inflation, measured by the price index for core personal consumption expenditures (PCE), now exceed its target in 2021, 2022 and 2023. The revision was largest for the current year, in which the median forecast now calls for core inflation to average 3%.

We, too, have been surprised by the magnitude of the surge in inflation this spring, which has multiple drivers. First, well-stimulated consumers are still buying lots of stuff, with production in sectors like sporting goods and furniture struggling to keep up with demand. Second, acute semiconductor shortages have constrained supply in, well, anything that uses a semiconductor. Appliances and cars come to mind. Third, labor shortages in reopening service industries have prevented some firms from quickly returning to full capacity now that many consumers want to fly, dine out and attend crowded events.

The nice part about all three of these factors is that they are likely to be temporary. Supply will eventually rise to meet demand, whether in furniture making, chip manufacturing or the labor force. But the unique and ongoing nature of these phenomena mean we can’t pinpoint exactly when inflation will turn over and begin to ease… and neither can the Fed. Powell could be in store for a few more awkward press conferences before he is proven right about the transitory nature of the current inflation bump.

Trust the Fed? The bond market does

Fortunately for the Fed – and investors, generally – markets seem to agree that the current bout of inflation will recede without forcing the Fed to tighten policy. In fact, despite rising by a few ticks after this meeting, U.S. Treasury yields are quite a bit lower today than they were the last time the Fed met. Even so, investors will notice the upward drift in the “dot plot” of individual FOMC members’ interest rate expectations in the coming years. The median dot now expects the Fed to have to raise its policy rate twice before the end of 2023, close to what money market futures had been pricing in prior to the meeting.

The bigger threat to diversified investors would be a sudden, unexpected tightening in monetary policy, which could send interest rates up, credit spreads wider and equity valuations down. Based on today’s outcome, we think this remains unlikely.

Yes, the Fed may eventually raise interest rates sooner than it expected to earlier this year. But this would come in the context of dramatically higher growth and inflation, so we would caution against interpreting the Fed’s posture as “hawkish” or even “more hawkish.”

Even so, as we roll toward 2023 – or whenever the Fed eventually makes liftoff – longer-term rates should begin to rise again, albeit in gentler fashion than they did in the first quarter of 2021. The U.S. economy has already surpassed its pre-pandemic output and is set to overtake its pre-pandemic trend output sometime in the next several quarters. At that point, it will be harder to argue in favor of zero interest rate policy.

Looking for income? Join the club

Whether rates rise or fall from here, investors still need to generate income from their portfolios. A further drop in rates, for whatever reason, would support bond returns in the short run but make income generation harder in the long run. Traditional bonds are an important part of a diversified portfolio, but they’re unlikely to generate anything close to the yield required by investors who are approaching or well into retirement. Higher income sectors include emerging markets credit and high yield municipals, while floating-rate securities like senior loans provide a more explicit cushion against rising interest rates.

As we’ve written in recent months, real assets like commercial properties and farmland provide a helpful supplement to a bond portfolio, particularly in a period of high inflation, strong growth and low real interest rates. Last, but not least, an income-focused equity strategy remains attractive when valued against most traditional fixed income benchmarks and holds more potential for capital appreciation as earnings grow into 2022.

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Dimitrios N. Stathopoulos
Head of Americas Institutional Advisory Services


Federal Reserve Statement, June 2021.
Bloomberg, L.P.

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