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The Fed’s New Conundrum

Guest Post by Ned Davis Research

Powell revealed in the press conference that the Committee began discussing when to taper asset purchases, as widely expected by market participants. They agreed that economic conditions have not met their criteria of substantial further progress, but will evaluate the progress at every future meeting.

Better economic outlook

As expected, the FOMC’s 2021 economic forecasts were revised higher. Real GDP was revised up to 7.0% this year from 6.5%
in March, matching the upper end of our projected range of 6.5% to 7.0%. GDP for next year was unchanged at 3.3% but 2023
was revised up to 2.4% from 2.2%.

The unemployment rate projections were little changed, with a small downward revision for 2022 to 3.8%. 

Powell mentioned several times during the press conference that they were expecting a very strong labor market in the coming months.

Inflation was revised substantially higher. Overall PCE in 2021 was revised up one point to 3.4%, while core PCE was revised to 3.0% from 2.2% in March. Projections for next year for both overall
and core PCE were bumped up to 2.1% from 2.0%. Overall PCE was revised to 2.2% from
2.1% in 2023.

Two rate hikes

As a result of the upward revisions to growth and inflation, some participants thought an
earlier rate hike would be the appropriate policy response, as shown on the chart. Seven participants now, up from four in March, believe that at least one rate hike would be appropriate next year. Of the 18 participants, 13 saw at least one hike by 2023, up from seven in March. Only five saw no rate hikes before 2024. The median participant saw two rate hikes by the end of
2023.

NDR has defined “substantial further progress” to mean moving at least halfway
between the November readings and the pre-pandemic peak/trough. The Fed probably won’t have enough data to make that determination until the fall when schools reopen and extended
unemployment benefits run out. We continue to expect the taper to begin in January 2022.

The new conundrum

What worries us the most is if inflation and inflation expectations are running above the Fed’s long-term target of 2% but we haven’t hit maximum employment. We expect the Fed’s new index of Common Inflation Expectations to continue rising, perhaps to its highest level since the index began in 1999. The Fed shouldn’t be overly concerned with a low-2s inflation
expectations reading for a quarter or two.

But if it persists or moves higher, the Fed will need to react. The Fed is assuming inflationary pressures are largely transitory and that long-term inflation expectations will be well anchored around 2%.

So the Treasury market needs to prepare for higher short-term rates, but ultimately the Fed will not let inflation get out of control, which could temper any rise in longer term yields.

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