Dialogue of the deaf
Our conclusion after the end of the latest Fed meeting on 17 March is that the dialogue of the deaf between the market and the Fed is likely to persist, with the latter possibly inclined to further ignore the Fed’s dovish ‘average inflation targeting’ strategy.
The meeting revealed that the Fed remains set on its dovish course. Asset purchases were left at USD120 bn per month and chairman Jerome Powell hinted it was too early to consider tapering. Projections by Fed officials (the ‘dot plot’) still do not see any rate hike in 2023, even though there was a big upgrade in the Fed’s 2021 GDP growth forecast to 6.5%. Unemployment is expected to drop to only 4.5% by year-end.
As the subsequent rise in long bond yields show, money markets continue to believe the Fed will blink, hiking more and sooner than it wants to say. The market seems rather anxious about the Fed’s sizeable upgrade of its 2021 GDP growth projection and slashing of its forecast for the unemployment rate. In former times, a 4.5% unemployment rate would be considered full employment and would prompt the Fed to increase rates to a ‘neutral’ setting.
Overall, we remain inclined to side with the Fed rather than with the money markets on the pricing of the first rate hike. We think a 2023 rate hike looks premature, especially in view of the Fed’s investment in its ‘average inflation targeting’ strategy and all that lies behind it (a greater focus on social inclusiveness and minorities, the implicit help the Fed has to give to fund the budget deficit, and soon, more involvement in the green transition). We continue to think the Fed will begin to taper its bond purchases in early 2022, with an announcement in the second half of this year—possibly after the release of Q2 GDP figures, which are likely to be very strong (likely above 10% annualised). The Fed could well take several months after such an announcement to actually commence tapering as it will want to keep expectations for the first rate hike at bay.
In the near term, one will certainly need to watch whether there is an extension of the supplementary leverage ratio waiver, which provides relief to banks on capital requirements. Also, the big gap between the Fed’s dot plot and money markets is echoed in the large discrepancy between actual inflation and (sharply rising) market-based inflation expectations. We need to see whether recent increases in inflation prove transient, as the Fed (and we) expect. As things stand, base effects and trends in oil prices mean we could see a peak in headline inflation around April/May.