Hot economy, higher rates
The US economy goes from strength to strength, supported by accelerating vaccinations, expansive fiscal policy, and easy monetary policy. The pace of vaccinations is running over 2 million doses per day, which will support economic growth through the reopening of the service sector. This would unleash pentup demand from consumers, given both how long it has been since people have been able to enjoy services, as well as the savings they have built up due to the closures.
The labor market added 379,000 jobs in February, and we expect the pace of job creation to pick up dramatically over the next several months. As for fiscal policy, President Joe Biden recently signed a nearly $2 trillion bill into law. This will support increased spending by both the government and the private sector, further accelerating growth.
Finally, on March 17 we received further guidance from the Fed as it reported on the outcome of its latest meeting. Importantly, we learned more about how the Fed will implement its updated strategy for monetary policy, known as FAIT (flexible average inflation targeting), in which the Fed plans to compensate for below-target inflation by letting inflation run above target for some time. Until now, we have had little information on either how far or for how long the Fed will abide above-target inflation. Its March “Summary of Economic Projections” shows that the Fed expects inflation to exceed 2% annually for most of the next three years, in fact hitting 2.1% for 2023, and that this will still not be enough to prompt a policy rate hike.
The Fed’s new strategy is a big change from the more traditional one it superseded, in which the central bank raised policy rates to slow inflation increases preemptively, before inflation hit target. The intention was to prevent an overshoot. Now the Fed intends to run the economy hot, and will not hike its policy rate until inflation is set to exceed its target for some time. It seeks to deliberately create an overshoot. The newness of this strategy means the market is taking some time to fully price it, and the Fed’s latest guidance brought another move higher in rates. The move is fully consistent with the Fed’s intentions, in that the market repriced its inflation expectations somewhat higher. Also, rather than bringing rate hike expectations significantly forward, the market has priced a somewhat faster pace of rate hikes when they do start. This has naturally led to further curve steepening.
We have adjusted our rates forecasts higher in light of recent events and what we have learned from the latest Fed guidance. The market pricing of inflation had moved higher but had not yet quite closed the gap with the Fed’s inflation objective. We still hold that view that as the cycle progressed and rates moved higher, the majority of that move would take place in real rates. We expect that if our forecasts prove correct, the majority of the move will be in real rates, with a much smaller move in breakeven inflation rate. This should remain a favorable environment for risk assets, as the move in real rates is driven by stronger growth, which will support better earnings, and inflation pricing moving to a level fully consistent with the Fed’s objective.
The large forces at work will lead to ongoing volatility. It is very important to note that the Fed’s guidance is outcomebased, not calendar-based. That means that the Fed’s projections will change as the economic recovery develops. If growth and inflation surprise to the upside, the Fed will likely bring forward the timing of its rate hikes. Both market pricing and our forecasts reflect those risks.