Fed Update 12-15-2021

Fed Note:

The Federal Reserve Open Market Committee made no changes in interest rates today, as expected, staying at the target of 0.00-0.25%.

However, in keeping with intensified market expectations in recent weeks (and signaled by the Fed itself), a key policy change was a doubling in the pace of tapering (to $30 bil./month) off of treasury and mortgage-backed bond purchases. This implies they’ll finish buying completely by early Q2 2022. The tone was a bit more hawkish than the market perhaps expected.

The formal statement language noted that a variety of sectors continue to be affected by Covid, including new variants, although job gains have been ‘solid in recent months’. Supply/demand imbalances were still noted as contributing to elevated inflation.

The dot plot seems to imply three rate moves next year, at a median rate of 0.75-1.00%. Compared to the September report, inflation forecasts have risen sharply from 4.2% to 5.3% in 2021, but only from 2.2% to 2.6% in 2022. The unemployment rate forecasts have moved in the other direction, moving lower by -0.5% this year and by -0.3% in 2022 (to a low 3.5% level). GDP expectations have fallen by -0.4% this year, with mixed results over the next several years.

Persistent inflation being no longer ‘transitory’ (per Jerome Powell’s words), has been the most important recent change in sentiment, with growing pressure to move away from accommodative policy. This also pulls the timeline for rate increases forward, from late 2022 to possibly as soon as mid-2022. This means next year could much more interesting than the last few years.

The Fed’s evaluation metrics remain mixed and heavily debated (and more fluid than usual):

Economy: It’s still apparent that the peak in recovery growth occurred around Q2 of this year, with Q3 having decelerated faster than expected along with concerns about the Covid delta variant. Now, the omicron variant threatens growth again, although much remains to be determined on the medical impact side. (The best case is that it features lessened morbidity, even if more infectious.) If it does prove more problematic, growth could be lowered by up to an estimated half-percent of GDP, as well as push that growth further into 2022. But growth expectations overall remain above trend as the ‘restart’ continues (5.0-6.0% for 2021 and 3.5-4.0% for 2022). As we move into 2023 and 2024, though, this growth is predicted to fall back to a trend level of 2.0-2.5%, which presumes Covid will eventually have neither a positive or negative impact on the economy long-term. From an economic growth perspective, the recessionary ‘emergency’ seems largely to have passed—reducing the need for stimulative help.

Inflation: The most recent figures are 6.8% and 4.9% for headline and core CPI, respectively. These are obviously well above the 2% Fed mandate, and more similar to levels indicative of the late 1970s-early 1980s. Per their own admission, the Fed has been willing to allow inflation to run ‘hot’ to offset the prior several years when inflation ran below 2%, but pandemic side effects pushed this even beyond their wildest hopes. Classic economic theory dictates that high and rising inflation necessitates higher interest rates, essentially applying the ‘brakes’ to activity (and high M2 balances). Today, the key issue has become one of inflation durability. After increasing criticism, the Fed has retired their description of ‘transitory’, with the question moving to how ‘persistent’ this inflation will be. The running joke among some economists is that now that Fed is worrying about inflation, the rest of us can stop worrying about it. Will it indeed be temporary, only lasting up to a year perhaps, and based on specific issues? Or, has it become more durable and secular? As have many economists generally, the Fed has been in the temporary camp, so is not overreacting. (At the same time, it’s important to acknowledge the inherent contradiction governments face with inflation. Higher inflation actually helps debt issuers by more quickly eroding away debt balances, ideally keeping real interest payments lower at the same time.)

Employment: The secondary mandate of the Fed is full employment. This is a difficult benchmark to measure, since the unemployment rate that equates to ‘full employment’ has never been defined, so we never really know when we get there. (It’s been postulated to be somewhere between 3-5%; there is never a realistic scenario where absolutely everyone is employed.) Labor conditions have steadily improved by a variety of metrics, in terms of job openings, higher wages, and quit rates, which point to high levels of worker choice. Recent gains have been seen in the recreation/travel/food service industries hit hardest by Covid, although they remain below pre-Covid levels. Overall, though, the broader jobs picture has experienced steady improvement.

It’s helpful to keep a broad perspective, even as Fed policy reverses course from extremely accommodative, to neutral, to eventually somewhat contractionary. The consensus view remains that recent inflation pressures are caused by supply/logistics hang-ups and high demand fueled by fiscal stimulus, which will take time to mop up. After the original Covid and several variants, the medical environment remains uncertain and fragile, particularly in the case of emerging markets, with lower vaccine distribution. The strong growth over the past year hasn’t been the organic kind, featuring labor force growth based on favorable demographics and long-term productivity improvements, but mostly a rapid bounceback from unsustainably low levels. This makes the growth numbers look impressively large, but they’re harder to sustain. Longer-term, demographic influences point to a return to lower growth levels not only in developed markets, but also in emerging, as China matures into a phase of higher-quality growth in manufacturing and services. Recent Chinese government actions have reflected changing priorities, from broad growth to a fairer distribution of sustainable gains across a larger cross-section of the population. A sea change may also be occurring in terms of manufacturing and trade, with ‘peak globalization’ perhaps in the rear view mirror (it had already been moving in this direction prior to Covid).

The Fed is a difficult position—it’s been trying to get back to neutral ever since the financial crisis. Is U.S. monetary policy behind the curve (rates should be rising already), appropriately still accommodative (due to remaining slack in the labor market), or just right? Short-term interest rates may certainly rise from here, which would reflect the improved economy and lack of need for emergency measures. Higher rates could also be argued due to higher inflation numbers. Those in favor argue not only for the sake of financial stability (too easy for too long can inflate asset bubbles and the excess taking of credit risk), but also to restock the monetary stockpile for the next recession or crisis. The Fed’s own assumed long-term neutral fed funds rate is 2.5%, which implies a 2% inflation target and a historically-appropriate 0.5% real yield. Getting there would require ten 0.25% rate hikes (and/or maybe a few 0.50%’s) over several years, assuming they can happen continuously, without recessionary easing needs in the meantime.

Paradoxically, the U.S. treasury yield curve shape (looked at from the perspective of 10-year rate minus 2-year rate) has flattened from a peak in steepness back in March. This has come from a 0.50% rise in the 2-year yield, as the 10-year has actually fallen a bit since then. The 30-year treasury yield has fallen by a greater -0.50%, which could also imply rising fears of a Fed policy error and investor seeking of safety in the event of an eventual recession. Falling rates don’t tend to imply upwardly-spiraling persistent inflation fears. In fact, the 5-year/5-year forward inflation expectation rate has bounced around between 2.1-2.3% over the last six months. Even the 5-year TIPS breakeven stands at a surprisingly low 2.6%, although this has been affected by low TIPS real yields. Lessened quantitative easing may put pressure on longer bond yields, with lower demand buying, but global demand for treasuries remains high.

Investors don’t always appreciate the short-term need for the Fed to raise rates, but it’s a critical job to ensure financial stability. As it was put by a Fed chairman decades ago, the job of the Fed is to pull away the punchbowl just as the party is getting started. However, in this case, it’s more like draining only a few cups from the bowl after a party lasting over a decade.

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