Fed doubles down on accommodation, eyes 2023 hike
All eyes were on the Federal Reserve following its second Federal Open Market Committee (FOMC) meeting of the year, as market watchers anxiously awaited any sign that officials are even beginning to think about a shift away from an easy-money stance.
Congress has passed two rounds of stimulus since the Fed last released economic projections in December, and economists and investors alike have become increasingly optimistic about the economic outlook. The Fed’s forecast has improved with the rest of them: Officials now see GDP growing 6.5% in 2021, up from their previous assumption of 4.2%. The jobs picture is also better, with the Fed projecting the unemployment rate will fall to 4.5% by year-end, down from December’s 5% assessment.1
Still, the central bank doesn’t appear ready to take its foot off the gas, saying it will maintain its current pace of bond purchases and hold interest rates near zero until “substantial further progress” has been made in the economic recovery. Most FOMC members expect to keep rates as is for the next two years, though seven of 18 members saw rates increasing in 2023.1
Here's the big picture.
The Fed factor
The Federal Reserve essentially sets the nation's borrowing rates—for everyone from major corporations to main street consumers. Low rates mean it’s cheaper to borrow money, which encourages spending and makes it easier for companies to invest in future growth. Easy money is generally good for stocks, not only because it’s a catalyst for growth, but also because low rates make bonds a less attractive investment option. Indeed, the major US stock indexes have hit multiple record highs since last August.
Recently though, the Fed’s easy stance, coupled with more fiscal stimulus and prospects for strong economic growth, have raised expectations for future inflation and driven long-term bond yields higher. Some market watchers have become skeptical that the central bank will really keep short-term rates low for as long as it has suggested.
The dual mandate
But Fed Chairman Jerome Powell has seemed steadfast in keeping things the way they are, underlining that pockets of the economy most negatively affected by the pandemic still remain weak. He’s stressed that the central bank’s new framework, which it adopted last summer, will allow the economy to run hotter for longer before the Fed needs to step in and cool it down by hiking rates.
Here are where both components of the Fed’s dual mandate—managing inflation and promoting maximum employment—currently stand:
Inflation has been running below the Fed’s 2% target for the better part of the last decade. Powell has said that he expects inflation to pick up, but only temporarily.2 He’s attributed the recent rise in bond yields to the market’s confidence in a robust economic recovery, as opposed to worries about runaway inflation.3
Unemployment, on the other hand, remains well above pre-pandemic levels—albeit down significantly from its 14.8% peak in April—and Fed officials have been adamant that they will need to see improvement in the jobs recovery across income, gender, and racial lines before hiking rates. There is still much progress to be made on that front. In February, for example, the unemployment rate for Black Americans surged to 9.9% from 9.2% in January.4
To be sure, the economy has come a long way from where it was 12 months ago, when the Fed pivoted to its “all in” stance. But it may still have a way to go before the Fed deems the progress “substantial” enough to tighten monetary policy. While policy makers may be standing pat on their guidance for now, rapid progress toward inflation and employment goals could cause the Fed to reevaluate its hand sooner than expected.
Here are a few indicators to keep an eye on:
- GDP: The Fed may have upped its annual GDP forecast by more than two percentage points, but that’s modest by some accounts. Some economists, including those at Morgan Stanley, think activity may return to its pre-pandemic growth trend well ahead of Fed forecasts, accelerating the timeline for rate increases.5
- Inflation: While Chairman Powell appears committed to his belief that any inflation above the Fed’s 2% target is likely transitory, some market watchers think inflationary pressures may be more than just a passing risk. Increased money supply, higher wages, and additional fiscal stimulus, set against a backdrop of pent-up demand for consumer services, may lead to inflation levels that require a Fed response.
- Signals from the markets: Our colleagues at Morgan Stanley have cited analysis of fed funds futures and overnight index swap markets that suggests investors expect the first rate hike could come in February 2023.5 The majority of Fed officials currently see rates remaining near zero through 2023.
Bottom line: As the economy moves further from its pandemic depths, investors should expect the market outlook to increasingly be guided by factors other than what’s driven it for the past year. Remember to stay the course and keep investing decisions focused on individual timelines, long-term goals, and risk tolerance.
- CNBC, “Fed sees stronger economy and higher inflation, but no rate hikes,” 3/17/21, https://www.cnbc.com/2021/03/17/fed-decision-march-2021-fed-sees-stronger-economy-higher-inflation-but-no-rate-hikes.html
- CNBC, “Fed Chairman Powell says economic reopening could cause inflation to pick up temporarily,” 3/4/21, https://www.cnbc.com/2021/03/04/fed-chairman-powell-says-economic-reopening-could-cause-inflation-to-pick-up-temporarily.html
- AP News, “Fed’s Powell: Recovery incomplete, high inflation unlikely,” 2/23/21, https://apnews.com/article/feds-economy-recovery-incomplete-d27f01cba34178de391f411cd1fbcc4d
- CNBC, “Job growth surges in February on hiring jump in restaurants and bars,” 3/16/21, https://www.cnbc.com/2021/03/05/jobs-report-february-2021.html
- Morgan Stanley Wealth Management, “Rising rates may signal significant market shifts ahead,” 3/1/21, https://www.morganstanley.com/ideas/rising-rates