The Federal Reserve has brought out their big guns. Just 6 weeks after their November 3rd FOMC meeting where they announced a taper to their asset purchases, the first step of removing accommodation in the system, the Fed has moved from a hypothetical observer to a decisive actor in what they see as a growing threat posed to our economy by inflation. Last week I shared our expectations of a number of significant steps the Fed would announce at yesterday’s meeting, and they did not disappoint. The Fed announced a doubling of the pace of taper, to $30bln a month. At this rate, they will be done buying assets for the QE program by mid-March; 3 months earlier than they had planned just 6 weeks ago. In addition, they altered their projections for PCE and unemployment significantly. They now expect core PCE to print 4.4% in 2021 vs 3.7% previously and 2.7% in 2022 vs 2.3% previously, a significant increase in core inflation over the next 13 months. Similarly, their projections for the unemployment rate fell to 4.3% from 4.8% in 2021, and 3.5% from 3.8% for 2022. Most would argue 3.5% is certainly lower than the natural rate of unemployment.
Why did the Fed change these economic projections and pace of taper? On the taper front, by speeding up the pace the Fed has bought themselves optionality to be able to raise rates sooner than they thought they would have to just 6 weeks ago. Remember, they have been very clear they do not want to raise rates before they finish their asset purchase program. Thus, by ending the program 3 months earlier, they can hike rates a whole quarter earlier than previously planned. Regarding the economic projections, the Fed has effectively admitted to getting the inflation picture wrong for the past year. Which brings us to Chairman Powell’s press conference yesterday….
Powell stated very clearly that the economy is growing substantially faster than the Fed expected and that their view of “transitory” inflation has proven incorrect. He spoke to inflation currently running significantly above their plan when they initiated Average Inflation Targeting. Regarding wage inflation, he warned that the Fed now views the lower Employment Participation Rate as a more permanent development, possibly due to people retiring early and being financially able to do so because of the significant home price appreciation and other asset appreciation they have experienced. Powell twice stated that this economic situation is significantly different than the last time the Fed tapered and then raised rates in 2013-14. With US growth so strong and inflation so much above their target, the lags between finishing the taper process and starting the rate hike cycle have all but evaporated. The bottom line is that the Fed has realized that their reliance on the concept of inflation being “transitory” has put them behind the curve and at risk of losing the confidence of the market. In an effort to restore the confidence they are going to aggressively change course, and now they have.
What does this mean for future Fed policy and the interest rates in the US? In my view, with the economy growing more quickly than expected and inflation a clear and present danger, an interest rate hike in March of 2022 is certainly on the table. When you look at what the next 3 months of economic reports may reveal, it is hard to believe that as concerned as Powell seemed at this press conference, that he won’t be more even so in March. Barring a significant deterioration on the Covid front, the next 3 unemployment reports and CPI reports should continue to pressure the Fed as they fall further behind in this rate cycle. Currently the market is pricing a 50% chance of a hike at the March meeting and an 80% chance of a hike at the May meeting; these odds seem too low to me. With the Fed’s credibility on the line, risk markets are betting the Fed will do the right thing, aggressively raise rates, and contain inflation. Sounds almost like a “perfect landing” for the Fed. But do they ever get it just right? It seems we are poised for even more volatility in the interest rate space as we head into 2022.