Greg Wilensky and Jason England explain that even with a modestly surprising update to its 2023 interest rate projections, the US Federal Reserve (Fed) still has the latitude to maintain accommodative policy until greater clarity on employment and inflation trajectories emerge.
- Despite a change to 2023 interest rate projections, Chairman Jerome Powell maintained a dovish tone during this week’s Fed announcement.
- Economic conditions have allowed the Fed to remain patient as recent weak payrolls data and subdued forward inflation expectations appear to justify an accommodative stance.
- Just as the Fed can be methodical in its approach, so too can investors as recent inflationary pressure appears transitory, and modestly higher bond yields may present opportunities that did not exist in late 2020.
Many of the recent Fed meetings have taken on the excitement of a lawn bowls tournament given how explicit Chairman Jerome Powell et al have been in their commitment to ultra-accommodative monetary policy over the medium term. Yet unlike other meetings since the height of the pandemic, the June 16-17 gathering merited our attention when considering the recent spike in core inflation (3.1% year-over year in April) and – counterintuitively – the past month’s slide in interest rates. How would the Fed reconcile these opposing forces, and what do they believe is worth monitoring in the months ahead? Importantly for investors, what does this all mean for financial markets?
Steady as she goes
As seen in its Wednesday announcement, the US central bank, overall, is maintaining quite an accommodative stance, despite a surprise increase in the Federal Open Market Committee’s (FOMC) expectations for 2023 benchmark overnight lending rates. That number, as measured by its DOTs Survey, rose from 0.125% (the zero bound) to 0.625%, implying that the median of voting members now expects two rate hikes of 25 basis points each during 2023. This step is likely a nod to the pace of the US economic recovery as lockdowns end and also perhaps represents a “hedge” that at least some of the much-ballyhooed transitory inflation may not be all that transitory.
For months, market chatter has been concentrated on consumer price levels. While the Fed sees prices rising faster in 2021 than previously anticipated, it does see the inflation rate rapidly converging toward its 2.0% target in 2022 and beyond. We consider the change in 2021 inflation expectations as a nod to the reality of recent consumer price data. Still, further-out projections indicate the central bank believes the acceleration in prices should be short-lived. Any pockets of inflation that prove stickier are likely welcome by the Fed. Lest we forget, one of the primary rationales for ultra-accommodative policy is to push prices upwards and cajole economic activity.
Speaking of the economy...
Many market observers believe that the opposing forces of weak jobs data and rising inflation were nudging the Fed into a corner. We, on the other hand, believe that recent economic developments have given the Fed exactly what it wants. The economic recovery from the depths of the recession has been astounding. With the cause being a natural phenomenon rather than an ‘own goal’ by financial markets – as was the case in 2008 – investors should have expected a vigorous bounce back. But with Fed credibility on the line, continued meteoric improvement could cause them to moderate their dovish intentions. Even with them raising 2023 interest rate expectations, we do not believe Wednesday’s statement marks a paradigm shift in interest rates, as futures markets were already pricing in a modestly faster pace to rate hikes than Fed forecasters.
As long as these forward-looking expectations do not signal runaway inflation – and after Wednesday’s Fed comments they definitely do not – we believe the central bank will have the latitude to remain patient in their approach to interest rate policy.”
Two successive weak payrolls reports, perhaps perversely, have given the Fed cover to be only slightly less dovish. Of the 22 million jobs lost at the height of the recession, the US economy is still 7.6 million short of reaching pre-pandemic levels (Source: Bureau of Labor Statistics, The Employment Situation - May 2021). Chairman Powell has made it clear that the Fed’s focus is on employment (and maybe the prices of riskier assets) and is willing to let inflation run ‘hot’ for a few quarters as long as it averages close to its 2.0% target over a longer time horizon.
Market-based inflation expectations, in our view, have also given the Fed a break. While lagging inflation data flash red, forward-looking indicators say ‘not so fast.’ In the past month, the level of annual inflation the Treasury Inflation Protected Securities (TIPS) market expects the US economy to average over the next decade has fallen from 2.56% to 2.34% – with a considerable slide after the Fed’s June statement. A similar decline is seen in 5-year TIPS implied inflation. As long as these forward-looking expectations do not signal runaway inflation – and after Wednesday’s Fed comments, they definitely do not – we believe the central bank will have the latitude to remain patient in their approach to interest rate policy.
While interest rates garner much of the attention, we believe that investors also should not ignore other policy tools the central bank has deployed during the crisis, namely balance sheet management. As evidenced by Wednesday’s announcement, low rates are locked in. More fluid perhaps, especially if the labour market regains its late 2020 momentum and inflation proves to be more persistent than expected, are possible tweaks to the central bank’s US$120 million in monthly asset purchases. In today’s vernacular, the time has arrived for the Fed to start talking about tapering its nearly US$8 trillion balance sheet. Unlike what occurred in 2013’s Taper Tantrum, we take Chairman Powell at his word that the central bank will be orderly, methodical and transparent in its approach to asset purchases.
Whereas interest rates are blunt instruments that impact the prices of financial assets and influence borrowing rates for consumers and corporations, moderating the level of asset purchases, especially in mid- to longer-dated securities, could represent a more subtle form of tightening, which could also serve markets well by further injecting term structure back into bond markets. This could lead to the dual benefits of incentivising banks to lend and allowing asset prices to be more influenced by underlying fundamentals of issuers rather than the presence of a gargantuan marginal buyer.
Bringing it home to investors
The year's rise in interest rates may have caught some investors off guard and it certainly proved a headwind for duration-laden portfolios. But it also sent the price of risk-free government securities to levels that allowed for a modest degree of yield advantage and a reintroduction of some diversification benefits with respect to riskier assets. Just as recent data should enable the Fed to be patient as additional economic developments unfold, we believe that interest rates within the current range, should allow investors to also be patient as they evaluate what is next for the economy and financial markets. Given the unprecedented nature of the recession, the speed of the recovery and the outsized influence of monetary policy, staying nimble during this dynamic environment continues to be an imperative.
Duration: a measure of a security or portfolio’s sensitivity to changes in interest rates. The higher the figure, the more sensitive it is.
Taper tantrum: markets’ reaction following the US Federal Reserve Chairman’s comments in May 2013, which suggested that the US was considering tapering (slowing down) the rate of its bond buying programme (quantitative easing).