The Federal Reserve left US interest rates unchanged at its latest policy meeting, but surprised with a hawkish tone that can be seen as indicating that the US economic recovery is picking up pace. Forecasts from the Fed for the 2021-2023 period included an unexpected hint of two policy rate increases by 2023, a year earlier than previously expected.
In the press conference that followed the Fed’s latest policy meeting, Chair Jay Powell confirmed that the officials has begun the process of discussing tapering its quantitative easing (QE) programme, the billion-dollar package of extraordinary bond purchases that the central bank unleashed to support the economy as the pandemic raged.
Although the US labour market – a focus area for Fed policy next to inflation – was still far from a state that would trigger the start of the taper, Powell was clear that he strongly expected employment to continue to improve over the summer and into the autumn. Indeed, Fed projections showed the unemployment rate is expected to fall to 3.5% in 2023 from 4.5% this year.
But the real action was in the area that Powell was least willing to talk about: the meaningful upward revision in the ‘dot plot’ of the forecast for the federal funds rate. The bulk of Fed policymakers now expect the policy rate to rise, via two rate hikes, each of 0.25%, from 0.00 – 0.25% this year to 0.50 – 0.75% by the end of 2023. In March none of them reckoned with such an eventuality.
Exhibit 1: The Fed ‘dot plot’: the bulk of policymakers now expect to have raised US rates at least twice by the end of 2023 and over a third expect to have increased rates by the end of next year
Source: US Federal Reserve projections, June 2021
Powell didn’t really engage with journalists asking why there had been such a sharp upward revision to the dot plot, but in our view, it doesn’t seem to be in response to the medium to longer-term economic outlook. The inflation forecasts in 2022/23 were barely changed, apparently underscoring that the recently higher-than-expected inflation can still be seen as transitory.
Instead, it looks like the Fed has concluded that the inflation surprises in recent months remove the need for anything but the most minor of overshoots of its 2% inflation goal over 2022 and 2023.
If that is how the Fed is now interpreting its new average inflation target (AIT) framework – and it’s not crystal clear that it is – it would likely make the bond market, especially real rates, more sensitive to inflation surprises in coming months.
The precise path of prices in response to the reopening shock that has affected the cost of everything from cars to hotels would now be seen as swaying the path of monetary policy in the next couple of years.
More upside inflation surprises, even if they are in transitory categories, would lead the market to conclude that the Fed will raise rates sooner. In contrast, signs that the supply shock is reversing (e.g., used car prices start falling) would be taken as the opposite signal.
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