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Fed Holds Rates Steady for Now

But more dots move toward a rate hike--or hikes--in 2022 or 2023.

In its latest statement March 17, the Federal Open Market Committee unsurprisingly held the federal-funds rate at 0.0%-0.25%. This wasn’t where the excitement was, as nobody expected a change in rates. Instead, the focus was on the release of new economic projections, as well as any hints of a change in the verbiage of the release related to what is now expected to be a strong recovery that might also push inflation higher. Based on our read of the Federal Reserve's most recent statements, we don’t plan to make any changes to our current rate forecasts in our U.S. bank models.

It’s easy at times to get lost in the minutiae--Did the Fed shift its rate forecast in 2023 by 25 basis points? Did inflation expectations shift by 10 basis points? Was there a word change in the release?--but we would emphasize three key points we gleaned from the Fed's recent statement.

  • We expect real GDP might be reaching or exceeding GDP potential by 2022, therefore resulting in a more inflationary environment.
  • We don’t expect the Fed to lose control of inflation.
  • The current increase in government spending may cause an increase in short-run inflation, but we would view this as temporary, giving the Fed room to ride out any temporary increases in inflation without resorting to rate hikes in the near to medium term.

Looking more closely at the release, we’ll start with the verbiage, in which there were really no substantive changes. The Federal Reserve gave a nod to some of the recent upticks in certain economic activity measures but emphasized that the sectors hardest hit still remain well below prepandemic levels, and inflation still remains below the Fed's 2% objective.

Moving on to the economic projections, there were some material changes. Projections for 2021 real GDP moved up substantially, from a median of 4.2% out of the December meeting to 6.5% out of the current meeting. Median expectations for unemployment in 2021 also improved, while expectations for personal consumption expenditure inflation edged up to 2.4% for 2021 from 1.8% last time around. The participants then expect inflation to fall back to 2% in 2022.

Notably, the median federal-funds rate projection stayed the same, keeping rates effectively at zero for 2021 through 2023. There was some movement on the dot plot, with three dots now expecting one rate hike in 2022 and one dot expecting two rate hikes, compared with only one dot last December expecting any rate hikes. In 2023, now seven dots expect one or more rate hikes compared with just five previously. The long-run rate estimate remained essentially unchanged.

Importantly, none of the participants expect to chase the increase in inflation in 2021 with rate hikes, and we agree. We expect future rate hikes to all come down to what the economy can support in equilibrium once the initial burst of inflation has worn off, and the Fed may decide to let the economy run hot for a bit even after the economy has reached its potential (which we expect sometime in 2022).

The response of inflation to the recovery remains a key area of debate and a key data point to watch. Inflation is important in this context because price stability is one of the Fed’s mandates; therefore, higher inflation could portend higher rates and a reining in of the economy. Higher inflation also affects yields on longer-duration securities, causing notional rates to increase. We have two main thoughts on this topic. First, we tend to agree that the economy will be pushing its limits, particularly with the stimulus package that was just passed. We haven’t seen government spending on this scale since World War II, and there appears to have already been pent-up demand in the economy. We expect that GDP could bump into or even surpass potential GDP levels by 2022.

At this point, we expect that much of the excess stimulus and demand in the economy would then be inflated away. However--and this second point is key--we also see the current increase in government spending as temporary. Therefore, the inflationary pressures (assuming they don’t cause a massive shift in inflation expectations) should also be temporary. The Fed has signaled that it has the same view--see recent remarks by Fed governor Lael Brainard on March 2, for example--and the Fed has given itself room to ride out any temporary boosts to inflation. Once the latest round of excess stimulus is burned off, we should return to equilibrium.

Many in the markets have noted the increase in yields on longer-duration Treasuries, which is very likely driven by increases in expected inflation and potentially increases in the term premium (which can be related to uncertainty about future inflation). The 10-year break-even inflation rate (the difference between 10-year Treasuries and 10-year inflation-indexed Treasuries) has continued to creep above 2%, implying that inflation may indeed start increasing.

Inflation is difficult to predict, and the data is mixed here. For example, the expected inflation from the Cleveland Fed’s model is still well below 2%. But the key point is that whether or not inflation happens, we think that if there is an initial burst in inflation driven by government spending, it will only be temporary, and the Fed has given itself plenty of room to keep rates lower for longer, even if inflation does temporarily get above 2%. In the event that inflation starts to creep uncomfortably above 2%, the Fed can still exercise control over demand and therefore control inflation. With inflation expectations seemingly solidly set, we don’t expect any loss of control with regard to inflation and the Fed.