The Fed’s Inflation Gamble
Dear Rich Lifer,
The Federal Reserve concluded its two-day meeting on Wednesday and announced higher than expected inflation in 2021 and a more rapid timeline for raising rates… two hikes in 2023.
But officials stopped short of revealing a timeline to cut back the massive bond-buying program. Fed Chairman Jerome Powell did say this issue had been discussed.
Powell commented, “You can think of this meeting that we had as the ‘talking about talking about’ meeting.”
Since the Fed’s last meeting, the labor market has had slower progress than anticipated. 837,000 jobs were added in April and May, leaving total employment 7.6 million jobs shy of pre-pandemic levels.
So what’s it mean for the economy… and your portfolio?
The timeline unveiled for raising rates was much faster than investors expected. Back in March, the Fed said it would hold interest rates steady through the end of 2023.
Then on Wednesday, 13 of 18 Fed officials indicated they expect to lift short-term rates to 0.6% by the end of 2023.
Seven officials expected to raise rates even sooner — by the end of 2022.
The benchmark federal fund rate has been steady since March 2020, when the coronavirus pandemic sent the economy into a spiral.
For now, rates remain near zero, but this sudden change in mindset has come as a shock to many. Including Mark Cabana, head of U.S. short rates strategy at Bank of America, who commented:
It appears to be a material shift in how the Fed sees the risks around inflation. That’s how I read it. It shows the Fed sees upside risks to inflation and that has presumably followed through to the dot plot.
No End in Sight to Quantitative Easing
The central bank has been purchasing $120 billion a month of Treasury and mortgage bonds since June 2020 to hold down longer-term borrowing costs and provide support to the economic recovery.
The Fed has maintained that it will continue to purchase bonds until “substantial further progress” has been made in the recovery.
Officials want the economy to get closer to two goals: first, “maximum employment” and second, sustained 2% inflation. Once these goals are reached, bond purchasing will be reduced.
Now, Powell says he believes these goals may be reached “ somewhat sooner than anticipated.”
He added that although the economy is making progress toward these goals, reducing bond purchasing still remains “a ways away.”
In coming meetings, scaling back bond purchasing will be addressed more seriously. The Fed is anxious to avoid the type of market “temper tantrum” that occurred when a similar bond scale-back was announced in 2013.
Inflation Fears Growing
Prices are rising much faster than Fed officials expected…
The Wall Street Journal reports,
Policy makers now expect the Commerce Department’s personal-consumption expenditures price index — their preferred measure of inflation — to rise 3.4% in the fourth quarter of 2021 from a year earlier, up from a March forecast of 2.4%. They revised up their projection for fourth-quarter-to-fourth-quarter economic growth to 7% from 6.5%.
Policymakers have become less confident that the economy will recover without increasing inflation.
Inflation has been higher than expected, with the Labor Department’s consumer-price index rising 5% in May from a year earlier.
This is the highest inflation rate we have seen since 2008. But many officials continue to stress that these are transitory inflation rates that will fade later this year.
One of the main stressors is the psychology of inflation, wherein continued inflation results in businesses and consumers anticipating more inflation in the future, which turns into a circular inflation trap. Powell warned, “We wouldn’t hesitate to use our tools to address that.”
However, Mr. Powell also noted, “Our expectation is that these high inflation readings that we’re seeing now will start to abate.”
He went on to explain that the biggest drivers of inflation were items like used cars, which are directly related to the pandemic. He explained further, “Much of this rapid growth reflects the continued bounce-back in activity from depressed levels, and the factors more affected by the pandemic remain weak but have shown improvement.”
Looking forward, Mr. Powell repeated that the Fed would give the markets plenty of advanced notice before withdrawing its current easy-money policies.
The Markets React
The Dow dropped over 300 points after the Fed’s update, before ending Wednesday around 240 points down. The S&P 500 and Nasdaq followed it down.
The benchmark 10-year Treasury yield rose about 5 basis points to 1.553%, while the longer-dated 30-year Treasury yield was at 2.197%. Meanwhile, gold prices sank 2.5% overnight.
Rob Subbaraman, head-global macro research at Nomura, said of the Fed meeting:
It’s clear from the FOMC meeting Fed is starting to turn a bit more hawkish and the risks, going forward, are that tapering and rate hikes could be brought for more, and so the risk is that at some point of time, we could have a snapback higher in US treasury yields.
Arvind Sanger of Geosphere Capital Management also weighed in on the future of yields stating:
I will be a bit patient but I am not panicking. This is inevitable; at some point, rates are going to rise and at some point, the 10-year yield is going to go at 2 percent, not in the near-term but it is going to get there as we normalise in the economy.
Only time will tell how soon the Fed will actually begin to reverse its policies from the past year. Until then, expect the markets to be volatile and keep your portfolio diversified.
To a Richer Life,
The Rich Life Roadmap Team