Higher prices and improving labor participation, support tighter policy
Dr. David Kelly
A rapidly improving labor market and persistent inflationary pressures has pushed the Federal Reserve (Fed) to adopt a more hawkish stance towards monetary policy. The Federal Open Market Committee (FOMC) voted to maintain the current Federal funds target rate at a range of 0.00%–0.25% and announced its plans to accelerate its tapering of asset purchases from USD 15billion to USD 30billion per month beginning in January. Compositionally, the committee will increase its reduction of U.S. Treasuries and agency mortgage-backed securities purchases to USD 20billion and USD 10billion per month, respectively. This strategy suggests the FOMC will conclude tapering by March 2022, paving the way for additional rate hikes next year, which look set to begin in the summer.
In the statement, the word “transitory”, previously used to describe the factors causing the current bout of inflation was retired, an acknowledgement of more sticky inflation that is expected to persist through next year. It also made clear that high inflation and a falling unemployment rate prompted the committee to hasten its tapering timeline. In addition, while it acknowledged the uncertainty on the economic outlook due to new COVID-19 variants, the combination of persistent supply chain pressures pushing prices higher and incredibly strong demand for labor outweigh the risks of staying patient in normalizing policy.
Elsewhere, the Fed delivered meaningful forward guidance by way of its updated summary of economic projections and median “dot” plot. Real GDP was downgraded from 5.9% to 5.5% year-over-year (y/y) in the fourth quarter of 2021, partially reflecting the delta driven 3Q21 slowdown, but potentially underappreciating the bounce back expected this quarter. With that said, it lifted its 2022 GDP estimate by 0.2% to 4.0%, possibly considering some further fiscal support and growth momentum carrying through next year.
Core and headline personal consumption expenditure (PCE) inflation were revised markedly higher by 0.7% and 1.1% to 4.4% and 5.3% y/y respectively in 2021, largely reflecting the jump in oil prices and core goods. Its projections also suggest stickier inflation with 0.4% increases to both its 2022 headline and core PCE forecasts. Notably, the committee’s 4Q 2022 core PCE forecast is 0.1% higher than its headline figure, suggesting a greater easing in the volatile food and energy component of inflation, while core components, like shelter costs and owners’ equivalent rent, could remain firm. The committee also expects a faster pace of improvement in the unemployment rate. It lowered this and next year’s target to 4.3% and 3.5%, respectively. This reflects the surging demand for labor, which should attract many people back to work, allowing for participation rates to recover.
With regards to the outlook on policy rates, the median voting member now expects three hikes next year and in 2023, a start shift from its September forecasts which only called for one hike in 2022. In general, today’s meeting reflects the committee’s view that the economy has made significant progress towards its goals and receding pandemic effects—notwithstanding omicron—have allowed for a faster pace of recovery into 2022, thereby supportive of an accelerated pace to tapering and the pulling forward of rate hikes.
Overall, investors should be prepared for an active Fed over the next few years. We expect the Fed to begin raising rates in June, and deliver one hike per quarter thereafter. In response to the announcement, equities moved higher and Treasury yields moved higher. Although the Fed is easing up on policy accommodation, it’s for the right reasons: growth is strong, prices are firm, and consumer balance sheets are healthy, suggesting a supportive backdrop for risk assets in 2022 and a more hawkish policy stance.