Fed meeting deflates reflation trade, for now

Brian Nick

The last week’s market highlights:

Each week, we present our featured topics in the context of the major themes listed below from Nuveen's 2021 Q2 Outlook
  • U.S. economy: A strong economic backdrop bodes well for U.S. economic growth.
  • Global economy: Should also surge as large developed countries sprint into the post-pandemic world.
  • Policy watch: No Federal Reserve interest-rate hikes until at least 2023.
  • Fixed income: Take more risk in credit-sensitive parts of the market.
  • Equities: Bullish on cyclicals but looking for opportunities again in growth.
  • Asset allocation: Consider benefits of active management amid idiosyncratic opportunities.

Quote of the week:

"The principle of give and take is the principle of diplomacy — give one and take ten.”
– Mark Twain

Dovish Fed in awkward position as inflation heats up

Last week’s meeting of the U.S. Federal Reserve’s Open Market Committee (FOMC) attracted more attention than most because of the events leading up to it. (The FOMC is the group within the Fed that sets monetary policy.) Since the Fed last met in April, U.S. inflation data has quickly accelerated while job creation has disappointed. That put Chair Jerome Powell and his colleagues in a tough spot: keep policy extremely easy until the unemployment rate falls further from its current 5.8%, or tighten policy to keep inflation in check.4
For now, the Fed has decided squarely on the first option. It’s clear the FOMC believes April’s spike in inflation is both transitory and even — up to a point — desirable, particularly compared to the pandemic’s early days, when month-over-month headline CPI fell below zero. (A complete lack of inflation is undesirable, while modest levels are an indication of a healthy economy.)
So even with the Fed’s dovish tilt, 13 of the 18 FOMC members now expect the Fed to increase rates in 2023, and the majority of them believe the Fed will hike at least twice that year. Moreover, seven think the Fed could begin raising rates as early as 2022.5 These are significant shifts forward in the anticipated timing of rate “lift-off” versus the last set of forecasts in March. The Fed also slightly upgraded its economic outlook, calling for GDP to expand by 7% in 2021, up from 6.5% in March.6
In its policy statement, the Fed notably did not mention any change in thinking regarding its current quantitative easing (QE) asset purchase program — currently a combined $120 billion/per month of U.S. Treasuries (about $80 billion) and mortgage-backed securities (around $40 billion). Pressed on this topic in his post-meeting Q&A, Powell said that the “substantial further progress” in the economy the Fed would need to see before reducing its pace of bond buying hasn’t been achieved.
He added that Fed officials would continue to assess the need for the QE program at upcoming meetings. We expect a Fed announcement on tapering those purchases to come after its annual Jackson Hole summit in August or at a subsequent FOMC meeting, with actual reductions beginning in the first quarter of 2022. If that doesn’t happen, it’s because the economy has undershot expectations, which signals a different set of problems.
Then there’s the hottest topic of them all: inflation. The Fed’s median forecasts for inflation, measured by the price index for core personal consumption expenditures (PCE), now show inflation exceeding its 2% target in 2021, 2022 and 2023. The upward revision was largest for the current year, with the Fed expecting core PCE to average 3%, compared to 2.2% in its March forecast.7
We, too, have been surprised by the magnitude of the surge in inflation this spring, which has multiple drivers. Among them:
  • Well-stimulated consumers are still buying lots of “stuff,” with production in sectors like sporting goods and furniture struggling to keep up with demand.
  • Acute semiconductor shortages have constrained supply in a wide range of products, most notably appliances and new cars.
  • Labor shortages in reopening service industries have prevented some firms from quickly returning to full capacity now that many consumers want to fly, eat at restaurants and attend crowded events.
On the bright side, all three of these challenges are likely to be temporary. Supply will eventually rise to meet demand, whether in furniture making, chip manufacturing or the labor force. But the unique and ongoing nature of these phenomena mean we can’t pinpoint exactly when inflation data will reverse course and begin to ease … and neither can the Fed. Powell could be in store for a few more awkward press conferences before he is proven right about the transitory nature of the current inflation bump.
What’s the bond market’s view of inflation? Fortunately for the Fed — and investors, generally — markets seem to agree that the current bout of inflation will recede without forcing the Fed to tighten policy. In fact, despite edging higher after last Wednesday’s meeting, the bellwether 10-year U.S. Treasury yield slumped on Thursday and Friday to end the week at 1.45%, well below its 1.63% close after the Fed met on March 17.8 (The yield on the 10-year note would be expected to rise if investors feared a sharp increase in inflation.)
In our view, the biggest threat to diversified investors would be a sudden, unexpected tightening in monetary policy. That could send interest rates up, credit spreads wider and equity prices down. We think the Fed is unlikely to pull any such unpleasant surprises. Yes, the Fed may eventually raise interest rates sooner than it expected to earlier this year. But this would come in the context of dramatically higher growth and inflation, so we would caution against interpreting the Fed’s posture under these circumstances as “hawkish.”
  1. S&P 500 via Haver, Marketwatch, treasury.gov
  2. Bloomberg
  3. National Bureau of Statistics of China via Trading Economics, Bloomberg
  4. BLS via Haver
  5. Federal Reserve
  6. Federal Reserve
  7. Federal Reserve
  8. treasury.gov
This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of Nuveen LLC, its affiliates or other Nuveen staff.
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