Did the Fed Just Blink on Inflation?
Did the Fed Just Blink on Inflation?
In a stare down contest did the Fed just blink at higher inflation and hence take the edge off their new policy framework? That seems to be the takeaway from all that they delivered on Wednesday afternoon. Recall the new policy framework they unveiled at Jackson Hole last August spoke of inflation averaging around 2% and since it had spent years under that level that having it spend some time above 2% was the desired path. At least that’s what we were told. After Wednesday, however, indications seem to be that the Fed remains as leery as ever of letting inflation spend much time above 2%. Seven participants want to lift rates as early as 2022 (up from four in March), and thirteen expect higher rates by 2023 (up from seven in March). While almost all Fed speak of late subscribed to the “transitory” characterization of inflation pressures, there was a little more hesitation when it came to the forecasts. We delve into that topic more below and what it may mean for yields across the curve.
Can We Put Names on Those Dots?
18 Fed participants supply their own rate and economic forecasts. 12 are regional Fed presidents (of which four are voting members that rotate on and off yearly). The NY Fed president gets a permanent voting slot. The remaining members are the six Fed governors who are also permanent voting members. They tend to drive Fed consensus, but that doesn’t prevent the regional presidents from offering their opinions. While the governors were unified in the “transitory” thinking, some presidents, namely Kaplan and Harker, had expressed a desire to get on with taper talk with some others, like Bostic, not far behind. We assume if they want to get on with tapering sooner rather than later that they want the same for rate hikes. Thus, we think most of those rate hiking dots in 2022 and 2023 come from the regional presidents seven of whom do not have voting privileges this year.
The point is that many of those hiking dots may not have the voting rights to carry out such a move. Just food for thought, but the market certainly took those hiking forecasts and pushed yields in the belly of the curve significantly higher reflecting a shorter period at the zero lower bound. Meanwhile, when you look at the 2022 and 2023 projections for GDP and inflation, both revert to pre-pandemic levels pretty quickly. 2022 GDP is projected at 3.3% and core PCE at 2.1% and remaining there. With inflation forecasted to return to near 2% next year, some participants, nevertheless, see upwards of six rate hikes before 2024. So while the new policy framework calls for some inflation averaging, many Fed members still see 2% as something of a ceiling. We’ll get plenty of Fed speak in the weeks ahead that will provide some more detail as to who is starting to get a little nervous over inflation and who is holding firm to the transitory story. We suspect those five dots in 2023 still holding to the zero lower bound are mostly, if not all, Fed governors who, as we mentioned earlier, tend to shape policy more than the regional presidents.
Yield Curve Quickly Reflects Fed’s New Rate-Hiking Scenario
One of the consequences of the pulling forward multiple rate hikes into 2023, and a growing number of Fed officials eyeing 2022 as a lift-off point, the Treasury curve quickly priced in some of that new thinking. The graph shows the 5Yr—30Yr Treasury spread and you see the nearly 16bps flattening in the curve with most of that coming from the 5Yr sector selling off given the shorter time frame to the first hike. Meanwhile, the 30-Yr didn’t move much as investors in those longer duration bonds were actually relieved to see the Fed is seemingly not so willing to let inflation run appreciably above 2% for any length of time, regardless of what the new policy framework says. Since the duration of many, if not most, of our clients’ investment portfolios resides in the 3 –5 year part of the curve, this repricing to a higher range, provides a better level for new investments.
TIPS Inflation Breakeven Rates- Yes, Again
We showed this graph last week, but wanted to update it with the latest Fed news and you can see the downtrend that was in place earlier with inflation breakeven rates continued after the Fed meeting and the revamped rate-hiking forecast. The question is what we brought up earlier as to who are the people behind those dots calling for multiple rate hikes in 2023, with seven of those eyeing a 2022 lift-off, and do they have a vote? If the Fed governors, who are permanent voters, are still holding to the transitory story in the weeks and months ahead, and willing to let inflation run a little before pulling away the punch bowl, some give-back in the latest move lower in breakeven rates may be in the offing. Looking at the Summary of Economic Projections offers some tantalizing fodder. While the median core PCE forecast in 2022 and beyond is 2.1%, the central tendency (excludes the three highest and lowest projections) peaks at 2.3% and the range (includes all projections) peaks at 2.5%. Obviously, one or more Fed members are indeed ok with some hotter-than-usual inflation, just like the new policy framework calls for. Look for Fed speak in the coming weeks to add more color to this.
|Treasury Curve||Today||Chg Last Wk.||LIBOR Rates||Today||Chg Last Wk.||FF/Prime||Rate||Swap Rates||Rate|
|3 Month||0.03%||+0.01%||1 Mo LIBOR||0.08%||+0.01%||FF Target Rate||0.00%-0.25%||3 Year||0.519%|
|6 Month||0.05%||+0.01%||3 Mo LIBOR||0.12%||Unchanged||Prime Rate||3.25%||5 Year||0.928%|
|2 Year||0.21%||+0.06%||6 Mo LIBOR||0.15%||-0.01%||IOER||0.15%||10 Year||1.455%|
|10 Year||1.48%||+0.04%||12 Mo LIBOR||0.23%||-0.01%||SOFR||0.01%|
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