Major stock indexes declined for the week, led by losses on Wednesday and Friday. Investors’ focus was on the conclusion of the Federal Reserve’s FOMC meeting. Although there was no actual change in policy, the Fed signaled that they could start raising interest rates quicker than expected to mitigate inflationary forces. While Fed officials have been consistently labeling inflation as transitory, they appear to be positioning for backup while attempting to avoid disturbing markets.
The Federal Reserve’s Federal Open Market Committee (FOMC) wrapped its June meeting on Wednesday with no actionable changes to current monetary policy. The federal funds target interest rate will stay at 0% – 0.25%, and the Fed will continue to purchase $120 billion of bonds each month as a quantitative easing measure. No surprises there. However, there has been some recent chatter of potential tightening due to inflation and pricing data. Did any of those discussions make it into FOMC discussions and projections?
Well yes, comments and projections did indicate a more hawkish monetary policy stance than previous meetings, driven by a stronger growth and inflation outlook. Compared to the April meeting, the statement language highlighted the continued improvement in economic conditions due to vaccination progress, but noted risks to the outlook still remain.
The Fed delivered meaningful forward guidance by way of its updated summary of economic projections. Projected Gross Domestic Product (GDP) was raised from 6.5% to 7.0% year-over-year for the fourth quarter of 2021. They also lifted 2023 GDP estimates by 0.2% to 2.4%, potentially considering further fiscal support impacting the economy. Core and headline personal consumption expenditure (PCE) inflation were revised noticeably higher to 3.0% and 3.4% year-over-year, respectively for 2021, compared to 2.2% and 2.4% projections in March. Inflation figures were also adjusted slightly higher for the subsequent two years. Together, the updated forecasts reflect the strong improvement in the broader economy and aggregate demand returning as the economy reopens.
Perhaps most notable, the median “dot plot” now reflects two 0.25% interest rate hikes in 2023, up from no rate hikes just three months ago. Moreover, 7 of 18 committee members expect a rate hike might be appropriate in 2022, up from 4 in March. This reveal was the most hawkish stance relative to expectations to come out of the FOMC meeting. However, we should note that this positioning could be potentially overstated. It is reasonable to ascertain that most of those 7 votes were from regional Fed Presidents, who are not permanent voters. In other words, while the dot plot appears hawkish versus expectations, in practice, it could potentially soften given how votes are distributed between hawks and doves on the FOMC.
Regarding quantitative easing, Fed Chair Jerome Powell at the post-meeting press conference said that while risks are abating, the economy is “far from” the goal of “substantial further progress” (in both its inflation and employment dual mandates) that the FOMC had set as a condition for reducing the current pace of asset purchases. The FOMC did “talk about talking about tapering” at the meeting, and the timeline for doing so is based on “the pace of progress, not a calendar”. The FOMC will update the public on the progress made toward its goals, and it will give advance notice of any plans to taper purchases.
The Fed’s shift to a more hawkish stance on Wednesday reverberated through global financial markets, with meaningful moves across and within asset classes as investors liquidated inflation hedges and faded reflation trades. The US dollar surged while interest rates retreated. Meanwhile, commodities took a hit, including gold and energy. Stocks slid as well.
The drop in the 30-year US Treasury bond yield is particularly noteworthy. Typically, the long maturity bond is highly sensitive to inflation expectations. If related, this rate is sending a message that the reflation trade is fading. In the wake of Wednesday’s Fed meeting, the 30-year rate fell to 2.01% as of Friday’s close – a four-month low.
And we got another dose of it on Friday. St. Louis Federal Reserve President James “Jim” Bullard (whose district includes Memphis) was interviewed on CNBC and gave a hawkish policy warning. Bullard sees an initial interest rate increase happening in late-2022 as inflation picks up faster than previous forecasts had anticipated. Bullard anticipates inflation running at 3% this year and 2.5% in 2022. “If that’s what you think is going to happen, then by the time you get to the end of 2022, you’d already have two years of 2.5% to 3% inflation. To me, that would meet our new framework where we said we’re going to allow inflation to run above target for some time, and from there we could bring inflation down to 2% over the subsequent horizon.” Bullard is not a FOMC voting member this year but will get a vote next year.
Before the Bullard interview, stocks were already in a weakening trend, but the pace of the declines accelerated from the time Bullard came on to the end of his interview. The 10-year US Treasury yield was basically flat heading into the interview, then spiked during Bullard’s comments and stayed at those levels until late morning before erasing all increases.
It makes sense for the Fed to signal a well-advanced timeline for interest rate hikes. It’s still a little early to tell if it actually comes to fruition or if a temporary wave of inflation flows through and renders this a moot conversation.
Have a great Sunday!
Timothy W. Ellis, Jr., CPA/PFS, CFP®
Senior Investment Strategist, Wealth Strategist