Amid faster-than-expected growth and progress against COVID-19, U.S. Federal Reserve officials indicated that the next hike in interest rates could come around the middle of 2023 and began talking about the prospect of tapering asset purchases.
Released on 16 June, the Federal Open Market Committee’s (FOMC’s) Summary of Economic Projections (SEP) implies that the Fed could hike interest rates twice in 2023 instead of 2024 or later, as it had projected in March. In addition, Fed Chair Jerome Powell told reporters that the committee started to discuss the FOMC’s options for ending the bond purchase program. Working backward from the new 2023 projected timing of the first rate hike, we think the FOMC could announce the first reduction in its bond purchase program as early as September.
Interestingly, the more hawkish changes to FOMC participants’ rate path expectations came despite little change in the 2023 unemployment rate and inflation forecasts. This suggests less tolerance for an inflation overshoot than previously thought.
We see the recent rise in inflation expectations as a welcome development because inflation expectations had likely been anchored below the FOMC’s 2% target. And Powell echoed these sentiments, noting that inflation expectations had recently moved back to a range more consistent with the Fed’s inflation objective. Nevertheless, the speed of the move higher in longer-term inflation expectations has likely raised some alarm among FOMC officials. These concerns, plus the perceived need to anchor inflation expectations at the target, likely contributed to the rate path revisions.
Inflation still transitory
Despite the greater focus on mitigating the risk of an unwanted rise in inflation expectations, changes to the SEP inflation forecast suggest that the Fed still believes the current inflationary spike will be transitory. The FOMC raised its core PCE inflation forecast to 3.0% in 2021 – a massive revision versus 2.2% projected in March – although it didn’t alter its forecasts further out.
We agree that the current bout of higher inflation will prove transitory. However, the risk of more persistent inflation hinges on inflation expectations remaining anchored. Consumers can react to the recent increase in prices in two ways. They could delay consumption on the view that prices will be lower later, or they could buy more now despite higher prices, believing that prices will be even higher later.
The latter scenario is what the Fed is trying to guard against; however, we think the economic evidence received so far is consistent with the former scenario. For example, real purchases of retail goods declined in April and May in the face of higher prices.
Nonetheless, recently, longer-term inflation expectations as measured by the TIPS (U.S. Treasury Inflation-Protected Securities) market and surveys have moved up somewhat. As a result, the Fed is likely focused on managing the risk of a further unwanted jump higher.
Talking taper but no substantial further progress
Ahead of the June meeting, FOMC officials in public comments unanimously agreed that the increasing vaccination rate and brighter economic outlook warranted the committee to begin talking about how they would ultimately end the bond purchase program. Consistent with this, Chair Powell acknowledged that the FOMC began discussing the balance sheet as part of prudent planning measures – even though the committee still expects it will be some time before “substantial further progress” toward the unemployment and inflation goals is achieved.
We continue to believe the Fed’s preferred plan and timing for tapering will become clearer in the coming meetings. However, after Wednesday’s meeting we now believe that the announcement could come as soon as the FOMC’s September meeting. When the Fed does taper the monthly pace of purchases, it will likely follow a pre-planned, gradual path that takes roughly two to three quarters.
Chair Powell reaffirmed that the committee wants to provide advance notice before any tapering decision. We suspect this could come in the form of guidance that states that the FOMC expects to meet substantial further progress “soon.”
The outlook has improved meaningfully since the last SEP was released in March. As result, FOMC participants’ focus has shifted from managing downside risks to the economy to managing upside risks to inflation expectations. This prompted the committee to begin discussions of tapering, and revise its forecasts for the expected path of interest rates. Nevertheless, we think the FOMC is still firmly committed to its new monetary policy strategy, but if conditions once again change the Fed’s outlook, its outlook for the balance sheet and rates will once again change with it.
Allison Boxer and Tiffany Wilding are economists and contributors to the PIMCO Blog.
Read “A Framework for Sizing Real Assets to Manage Inflation Risks” for further insights into the inflation outlook and investment implications.