Same Dovish Tune with More Hawkish Melodies
Dr. David Kelly
The rollout of COVID-19 vaccines and the passing of a further USD 1.8trillion fiscal package has brightened the economic outlook and today’s meeting gave investors a gauge on how this might adjust monetary policy in the years ahead. The Federal Open Market Committee (FOMC) voted to maintain the current Federal funds target rate at a range of 0.00%–0.25% and reaffirmed its commitment to USD 120billion in asset purchases per month, until the committee feels “substantial further progress” has been made towards its inflation and employment goals.
Relative to the January meeting, the statement language noted the recent improvement in economic conditions in the first few months of the year after softening last quarter. It also removed some downbeat language related to oil prices and softer demand. Still, it continued to highlight the uncertainty around the outlook caused by the pandemic.
Notably, the Federal Reserve (Fed) delivered meaningful forward guidance by way of its updated interest rate and economic projections. Real GDP was materially upgraded from 4.2% to 6.5% year-over-year (y/y) in the fourth quarter of 2021. However, only a small improvement was applied to 2022, and 2023 growth was downgraded by 0.2% to 2.2%. This strongly reflects the committee’s view that the fiscal burst will prove to be short lived and that growth should moderate as the majority of fiscal support is deployed this year.
Its forecasts of the unemployment rate were revised lower to 4.5% and 3.9% for the fourth quarters in 2021 and 2022, respectively, and reach pre-pandemic lows of 3.5% by the end of 2023. Such a rapid decline in the unemployment rate is likely to bring people off the sidelines and back into the labor force, allowing for the robust recovery in labor market conditions the committee is targeting.
Notably, core and headline personal consumption expenditures (PCE) inflation were revised markedly higher to 2.2% and 2.4% y/y, respectively in 2021, but are expected to cool to 2.0% next year and run only slightly above 2.0% in 2023 as the unemployment rate grinds back to pre-pandemic tights. Given the new framework, we recognize the Fed will tolerate higher realized inflation, however, it remains to be seen just how much inflation. Still, it’s fairly clear that modestly higher inflation won’t prompt any policy adjustment this year.
In addition, the median federal funds rate projection—as measured by the “dot plot”—continues to imply no rate adjustments through 2023, however the committee, on average, appears to have shifted slightly more hawkish. Relative to the December projections, four committee members now foresee a rate hike in 2022, up from one; and seven expect a rate increase sometime in 2023, up from five.
Separately, while little was gleamed from the press conference, Fed Chairman Jerome Powell implicitly reinforced the Fed’s commitment to data dependency by stating that “actual progress, not forecast progress” will be assessed in adjusting its interest rate policy and quantitative easing program. Moreover, Chairman Powell explicitly stated it’s still too early to consider tapering and the committee would provide ample time before reducing policy support. Therefore, we expect the committee will continue its pace of purchases through 2021 and begin to signal tapering in early 2022.
It should be emphasized that despite a more optimistic view on unemployment and economic growth this year, the overall outlook for Fed policy remains very dovish and today’s communication further solidifies its easy stance at least through the end of 2022. Equity markets rallied and the U.S. 10 year yield fell on the back of the news as a commitment to its new Flexible Average Inflation Targeting framework should keep monetary policy easy over the next couple of years. However, investors should be positioned for higher yields as boomy growth and higher inflation are realized later this year.