Market Views from the Global Fixed Income, Currency & Commodities (GFICC) group

The Federal Open Market Committee (FOMC) voted to maintain the current Fed Funds rate at the zero lower bound (0.00%–0.25%) and begin tapering its asset purchase program by 15bln per month starting in mid-November. The Committee agreed that “substantial further progress” on both of their mandates had been achieved, justifying a reduction in the pace of bond buying, while maintaining stricter forward guidance criteria for raising the Federal Funds rate.

Committee Statement

• Economic Assessment – The economic assessment was changed slightly as the Committee maintained an optimistic tone on the recovery, but tweaked its language on inflation. Whereas previously they attributed inflation to “transitory factors”, these factors are now “expected to be transitory” reflecting increased uncertainty around the outlook. Furthermore, they commented that the rise in inflation is not due solely to supply constraints, but also demand imbalances.
  
  
• Outlook – The Fed continues to view the path of the economy as dependent on the course of the virus, but also referenced for the first time the ongoing supply constraints and its ripple effects on economic activity, employment, and inflation.
  
  
• Current Policy and Forward Guidance –
  
  
  • The Fed viewed that “substantial further progress” on its goals had been met and that tapering was appropriate. The Fed announced a reduced pace of purchases starting in mid-November of USD 70 billion (gross) per month in Treasuries and USD 35 billion USD (net) per month in Agency Mortgage-Backed Securities. The Fed anticipates that it will continue to reduce the pace by 15bln per month assuming economic conditions develop as the Committee currently anticipates.
    
    
  • On the timing of rate hikes, the Committee maintained its prior guidance that policy rates will remain at zero until the labor market has achieved full employment and PCE has reached 2% and is on track to exceed 2% for some period of time. Furthermore, the FOMC has committed to maintaining more broadly accommodative monetary policy until inflation averages 2% as long as longer-term inflation expectations are anchored.

Chair’s Press Conference

At the press conference, Chair Powell made several important comments relating to inflation, the labor market, tapering, and rate hikes:

• Inflation: Chair Powell reiterated his belief that transitory factors were responsible for most of the uptick in inflation. He admitted inflation was likely to stay elevated for longer than previously anticipated and uncertainty was high around this view as global supply chains are complex. He communicated that high inflation was not the result of a tight labor market but instead a function of very strong aggregate demand and supply chain bottlenecks. He anticipates that inflation will decelerate in Q2 or Q3 of next year.
  
  
• Labor market: The Chairman remained optimistic on the prospects for the labor market and future improvement in labor supply. When asked about recent wage gains, he viewed wage growth as in line with productivity and inflation and not at risk of spiraling higher. Chair Powell is still waiting for more time to assess the labor market in a “post-COVID” world.
  
  
• Tapering: While tapering is expected to be reduced on a monthly basis, Chair Powell reminded reporters that tapering will still be data dependent and reviewed at every FOMC meeting. They are prepared to speed up or slow down taper if economic conditions warrant but assured the market that they would be transparent and provide warning ahead of time. By starting the tapering process, Chair Powell believes that the Fed’s policy properly positioned to address the range of plausible outcomes and is not “behind the curve”.
  
  
• Rate Hikes: Chair Powell reiterated that the criteria for tapering and tightening policy were distinct and that the economic conditions will determine whether a rate hike is warranted. Chair Powell stressed that since maximum employment has not been achieved that it was not the right time to assess if rate hikes were appropriate. When maximum employment is reached, inflation would be assessed at that time.

Our View:

• The labor market has recovered nearly 80% of the jobs lost during the worst of the pandemic, but labor force participation remains depressed and employment is still ~5 million below pre-pandemic levels. The traditional disinflationary cycle that occurs after a recession has been short-circuited by the immense fiscal and monetary policy response. Shelter and wage inflation are showing enough signs of persistence that even after transitory factors fade, it is becoming increasingly clear that inflation will remain far above the Fed’s mandate for longer than previously expected, and when it does moderate, it will likely be at levels that remain above 2% on Core PCE.
  
  
• As it relates to tightening policy, we believe the Fed will stay the course and taper at a steady pace of 15bln per month allowing QE to be fully phased out by June 2022. Nevertheless, despite the end of asset purchases, we expect the Fed to keep policy accommodative due to elevated unemployment and still depressed labor force participation. For this reason, we do not expect the Fed to hike rates until they have had sufficient time to re-assess the landscape post QE.
  
  
• The length of the pause between the end of taper and the first hike will be dependent on job growth, the trajectory of the core inflation profile, and an assessment of long term inflation expectations. In our base case scenario where YoY inflation decelerates in 2H22 and inflation expectations remain anchored, we believe the Fed will pause after tapering and will be more patient in hiking rates than the market is currently anticipating.
  
  
• We expect the 10-year U.S. Treasury yield to rise with a 6-month forward range of 1.5% - 2.0%. U.S. Treasury yields should be biased higher as a result of continued robust nominal growth and the beginning of the removal of policy accommodation.