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Fed Optimism Shifts Rate Hike Sooner

RFP
The Federal Open Market Committee (FOMC) unanimously voted to keep short-term interest rates unchanged and the pace of asset purchases at $120 billion per month. The statement following the June meeting was much more upbeat about the progress of vaccinations and the economy. The statement swapped out a reference about the “hardship” COVID has wreaked around the world for the promise that vaccines have delivered in terms of reopening the economy. That is the most optimistic stance the Federal Reserve has taken with respect to the U.S. economy since January 2020, before the pandemic took hold.

The Fed revised up its quarterly forecast for growth and inflation significantly. The usually conservative Fed is now forecasting 7% growth for the 2021 outlook, which would be the strongest since 1984. It is within striking distance of the strongest growth in 70 years. This is despite some disappointment in the progress of employment. The moves prompted a majority of participants at the meeting to shift forward their expectations on rate hikes from 2024 to 2023; the number of participants expecting a 2022 rise in rates nearly doubled from four to seven.

Chairman Powell opened the press conference following the meeting with uncharacteristically bullish language on the economy. He replaced the terms “moderate” and “modest,” which have dominated Fed rhetoric since before the pandemic, with “strong,” “solid” and “supply constraints” to describe what we are seeing. He called the flare in inflation “notable.”

That said, he was disappointed in recent employment gains. He cited four reasons for the slowdown in employment from the initial reopening we saw in 2020: 1) It’s harder to find a job when you are no longer connected to your previous employer; that creates a speed limit on employment growth that was not there a year ago; 2) fear of returning to work is still high, with frontline workers facing more hazards than they did before the pandemic; 3) childcare needs are likely to linger until schools fully reopen in the Fall; 4) and, to a much lesser extent, supplements to unemployment insurance (UI), which will be removed for some 15 million workers between now and early September. Fed Governor Lael Brainard, who has a strong voice on the Board of Governors, argued in early June, “It is difficult to disentangle the effects of concerns about contracting the virus or caregiving responsibilities brought on by the pandemic from those of the UI benefits.”

We expect Powell to focus on tapering at his keynote address for the Federal Reserve Bank of Kansas City’s Jackson Hole, Wyoming annual conference. Powell admitted that the Fed is now actively discussing a tapering of asset purchases. He restated that the Fed is committed to providing a tapering process that is “orderly, methodical and transparent.” The Fed’s goal is to avoid a taper tantrum like we saw in 2013. We expect tapering to begin by year-end and to be completed before the Fed raises rates in 2023.

The Fed did adjust the interest on excess reserves (IOER) and the overnight reverse repo rate up by 5 basis points. That was merely meant to be a technical adjustment to get the fed funds rate up a bit. The Fed would like to see the fed funds rate trading closer to 0.125% than 0.06%, which is where it has been in recent months.

Bottom Line
Powell tried to reassure the public and financial markets that the Fed will not allow inflation to get out of control. The Fed’s own forecast, or “dot plot” as it is called, showed a substantial move up in the timing of rate hikes. The problem for financial markets is that inflation and rate hikes are always unwelcome.

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