Forward looking estimates may not come to pass. Sources: BlackRock Investment Institute, Federal Reserve and Federal Reserve Bank of New York, with data from Refinitiv Datastream, May 2021. Notes: The chart shows expectations for the federal funds rate, the Fed’s policy target. Market pricing is based on futures on the U.S. dollar Secured Overnight Financing Rate. We use the median forecast in the March 2021 Survey of Market Participants by the New York Fed. The BII assumption is part of our economic projections in our capital market assumptions. The Fed median dot plot comes from the January 2021 Summary of Economic Projections.
The Fed has reiterated its intention to stay behind the curve on inflation under its new framework that implies inflation overshoots to make up for past misses. Yet this has been met with some skepticism in markets, against the backdrop of a powerful economic restart. Current market pricing and consensus expectations suggest the federal funds rate, the Fed’s policy rate, would start rising much sooner than Fed officials’ own projections would indicate. See the chart above. We see two reasons for this disconnect. First, investors may be over-extrapolating from near-term growth data amid the powerful economic restart. We view the Covid shock as more akin to a natural disaster followed by a rapid “restart” – instead of a traditional business cycle recession followed by a “recovery.” That implies the huge near-term growth spurt will be transitory. And second, we believe many are still wedded to the central bank’s old policy framework, and may underestimate the central bank’s commitment to push inflation above target.
Market chatter about a potential tapering of the Fed’s asset purchases has gotten louder, yet we don’t see the Fed discussing this imminently. Tapering is the first step towards normalization of Fed policy, but even a discussion later this year does not mean the liftoff is close. There is a risk the discussion could trigger market volatility or be miscommunicated by the Fed. We believe investors should look through any such bouts of volatility, as our new nominal theme implies that the Fed will likely be much slower than in the past to raise rates in the face of rising inflation.
Inflation – not the near-term growth outlook – is key to the Fed’s rate outlook under the new framework, in our view. We believe two important developments would need to take place before the Fed considers a liftoff. First, the realized core personal consumption expenditures (PCE) price index, the Fed’s preferred inflation gauge, should stay at or around the Fed’s 2% target for a sustained period of time. The current inflation overshoot doesn’t meet the bar as the Fed views it as driven by transient factors. We also see uncertainties around the near-term persistence of the overshoot as the restart has led to unusual supply and demand dynamics. This is why we have recently closed our overweight in inflation-linked bonds over the tactical horizon. Second, the Fed’s inflation forecast would need to rise from current levels and point to a prolonged period of moderately above-target inflation. What could potentially pull forward the Fed’s timetable for a liftoff? An upward spiral in prices and wages set in motion by behavior of individuals and firms could be one driver, in our view.
The bottom line: The Fed is in the process of building credibility in the framework and has set a high bar to change its easy policy stance, even in the face of higher realized inflation. This implies that eye-popping growth numbers in coming months will be largely irrelevant to its rate outlook – and the restart momentum shouldn’t be over-extrapolated, in our view. The implication: stay invested as the restart broadens out. We are still pro-risk, but the support for this stance has shifted from our expectation for the restart to surprise to the upside to our belief markets are underappreciating the Fed’s commitment to its new framework. Risks to this view include market overreaction to the near-term growth rebound and worsening virus dynamics. We believe the near-term spike in inflation is barely making a dent in the cumulative inflation shortfalls after many years of misses, and expect medium-term inflation to gradually rise. Over the strategic horizon, we are underweight nominal government bonds and prefer inflation-linked bonds.
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