Fed takes a hawkish turn as it sees downside risks ease

At its most recent meeting on June 15 and 16, the FOMC made a surprising forecast for an earlier and faster adjustment in interest rates over the next several years. This seems to reflect the Fed’s growing confidence regarding the economic outlook, as vaccination rates increase and Covid-19 disruptions ease. It also indicates some concerns around upside risks to inflation, even if the central view is still firmly that the latest spike will be transitory.

Fed Chairman Jerome Powell tried to play down the shift in the dot plot (Chart 1), and rightly highlighted the uncertainty over this horizon. However, this hawkish shift does make us more likely to expect an additional interest-rate hike in 2023.

The shift in the Fed’s dot plot, which shows each FOMC member’s forecast for the fed funds rate, was remarkable. In March, 11 members were in favor of holding rates unchanged through the end of 2023. Now, this number had shifted to five, and of the 13 members who support an interest-rate hike, eight want to do so three times or more. This pushed the median dot higher to show two rate hikes in 2023. While the median forecast for no change in 2022 remains, the question of interest-rate hikes is becoming increasingly contested, with seven FOMC members predicting hikes on this horizon.

Chart 1: FOMC June dot plot

Chart 1: FOMC June dot plot

Source: U.S. Federal Reserve, “Summary of Economic Projections,” June 16, 2021.

What prompted this reassessment? The Fed’s press release struck a more upbeat tone on the coronavirus pandemic. The focus is no longer on the severe economic hardship the pandemic has caused, but rather on rising vaccination rates and decreasing new Covid cases. This could reflect the Fed’s increasing confidence around the recovery as the pandemic eases and downside risks recede. However, FOMC members made only small changes to their central growth forecasts this year, bringing these closer to our view.

The bigger question is: What role has the recent surge in inflation played? Powell conceded that the impact of supply-chain bottlenecks has been larger than anticipated. However, he continued to argue strongly that these would be transitory.

FOMC members’ inflation forecasts seem to match this story. The median expectation was, of course, up sharply this year to 3% (core PCE), but barely changed at 2.1% over 2022 and 2023. However, it’s worth noting that higher expected interest rates over this period have played a role in capping some forecasts. Even so, it’s clear no one is forecasting unruly inflation, with the range of expectations for core PCE in 2023 peaking at just 2.3%. However, interestingly, members have become increasingly concerned about upside risks to these central views, which could help explain this hawkish shift (Chart 2).

Chart 2: FOMC member assessment of uncertainty around their projections

Chart 2: FOMC member assessment of uncertainty around their projections

Source: U.S. Federal Reserve, “Summary of Economic Projections,” June 16, 2021.

Powell was open to the possibility that high inflation could prove more persistent, and he made it clear that the Fed has the tools to deal with this if necessary. While he welcomed the rise in inflation expectations to levels more consistent with the Fed’s target, he noted that increases significantly beyond this would require a policy response. This presents a clear pushback against the narrative that the Fed will let inflation run even if more persistent trends start to emerge.

Where does this leave our policy view? Powell was keen to play down the dot plots, saying these should be taken with a grain of salt. The underlying hint was that Powell himself is probably below the median dot. Of course, it could also be possible that the core of the committee sits on the more dovish side. However, the breadth of the adjustment in interest-rate expectations suggests that many members expect to hit the threshold for interest-rate hikes under the Fed’s new average inflation targeting (AIT) a little sooner than anticipated. This threshold has always been opaque and Powell admitted at the meeting that the look-back period over which the average is determined is discretionary.

It now seems most likely that the Fed will introduce two interest-rate hikes in 2023, as opposed to the single move we expected previously. Per Powell, this adjustment would be pulled further forward, and be more aggressive, if the Fed is wrong in believing that the latest surge in inflation is transitory. Otherwise, the triggers for setbacks to this schedule include a resumption of the Covid shock and/or a bigger deceleration in inflation. The latter would imply a path inconsistent with the Fed’s AIT and could keep policy on hold for longer.

Otherwise, Powell announced that the Fed is now “thinking about thinking about” tapering, representing another slightly hawkish shift in the Fed’s latest communication. He concluded that there won’t be a tapering announcement in the near future, but indicated that such an announcement would be well signposted. He confirmed that the Fed is some way off the substantial progress that it has deemed necessary to announce a wind down in asset purchases. Powell refused to give more specifics on timings, underlining instead that this decision would be data driven.

This signal and implied calendar sits fairly close to our expectation that a pick-up in the labor market over the summer could prompt an announcement on asset purchases at perhaps at the Jackson Hole Economic Policy Symposium in late August or the FOMC meeting in September. This could set up an eventual start to tapering in January 2022. It’s possible that this timeline is compressed slightly to December of this year, but the Fed would need to be pretty hurried to start earlier than this, given its repeated promises to provide long leads on any signals.



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