Fed View: Projections confirm dramatic shift in reaction function… – The FOMC left policy on hold today, and signaled that rates would stay on hold at least until the end of 2023. The projection on rates was even more dovish than our expectation – we thought the Committee would signal one rate hike in 2023 – and much more so than current market expectations of 2.5 rate hikes. This came alongside a significant upgrade to growth forecasts (with 2021 growth projected at 6.5% Q4/Q4, compared with 4.2% in December), and more modest upgrades to inflation and labour market forecasts. As expected, the view on inflation is for only a transitory pickup this year to 2.5%, followed by a return to around 2% in subsequent years. Notably, unemployment is now projected to undershoot the level consistent with full employment (4.0%) already by next year (when its forecast is 3.9%), and significantly so by 2023 (3.5%). The fact that the Fed sees rates remaining at zero in such an environment reaffirms the dramatic change in its reaction function following the adoption of its new average inflation target; back in 2016, the Fed’s projections were for rates to rise to 3% under similar labour market conditions. In the press conference, Fed Chair Powell emphasised this break with past Fed behaviour – saying that the goal of the Committee was to act now on ‘actual data’ rather than mere projections, as in the past. Indeed, in the previous cycle, the Fed raised rates on the expectation that inflation would meet its target, rather than it actually achieving its target; as we know, inflation indeed failed to meet these optimistic forecasts.
…but it seems markets still need some convincing – Despite this, it appears markets need more convincing, whether that is on the outlook for inflation, or on the Fed’s reaction function itself. While 10y Treasury yields came off around 5bp following the published projections and remarks by Powell, yields remain some 70bp higher than they were at the turn of the year. When questioned on the rise in yields, Powell essentially avoided comment on the matter (he appeared even to read off a prepared script). Instead, Powell emphasised that the Fed looks at a broad range of indicators of financial conditions. This is consistent with commentary we have seen from other FOMC members, who have been largely relaxed about the rise in yields. This is likely to remain the case for as long as yield rises are driven largely by inflation expectations, and for as long as they do not cause a significant broader tightening of financial conditions (of which equity markets are a large component in the US). With that said, we continue to think market expectations embedded in currently elevated yields have got ahead of themselves. We concur with the Fed that the rise in inflation this year will prove transitory, and once this is confirmed, elevated market-based inflation expectations will likely ease. We also view market expectations of rate hikes as too aggressive, and that these expectations will ultimately be priced out as the market becomes more convinced of the shift in the Fed’s reaction function. (Bill Diviney)