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WHAT HAPPENED: At today’s Federal Reserve meeting, the Federal Open Market Committee (FOMC) reiterated its guidance and maintained its asset purchase programme, despite a significant upgrade to growth and inflation projections for 2021, unveiled as part of the latest Summary of Economic Projections (driven mainly by the significant additional easing in fiscal policy). Chair Jerome Powell once again flagged a very patient approach, acknowledging the change in the reaction function (i.e. the Fed’s new average-inflation targeting framework, FAIT), which is now in place. Today’s meeting was very closely watched given the recent sharp rise in yields that preceded it.
OUR INTERPRETATION: The FOMC statement, the latest dots (which continue to show median rate hike expectations for the end of 2023, even though seven members now see the rate lift-off in 2023 compared to five previously) and Chair Powell’s comments reflect the underpinnings of the Fed’s new reaction function, which sends a dovish message. Chair Powell commented that, this time around, the Fed will wait for inflation to rise rather than rely on forecasted increases as a basis for tightening policy, given previous failures. This stance reflects a central bank that is significantly more tolerant of higher inflation during this cycle. However, despite the recent sharp rise in yields, Chair Powell indicated that financial conditions remain very easy, justifying the lack of any tangible additional action at this meeting, which was in line with our views.
OUTLOOK: We continue to believe that we are in highly abnormal times, and the Fed’s new reaction function reflects this new structural reality of continued low real rates. The Fed is currently pinning its hopes on transitory inflation spikes, despite the very significant fiscal easing in the pipeline, to justify the current accommodative policy stance as the central bank waits for ‘substantial progress’ before changing policy. However, we continue to think that further tests of credibility lie ahead for the Fed, especially as realised growth and inflation data starts to surprise on the upside as re-opening and growth stimulus from the very strong fiscal easing kicks in. Here, we think that risks to actual growth and inflation outcomes are significantly to the upside compared to the Fed’s current projections. In the background, the very high and rising debt burdens also imply a different objective function that requires monetary policy to focus on keeping debt service ratios low.
ASSET ALLOCATION VIEWS: This positive growth outlook, albeit with a number of risks still intact, drives our multi-asset team’s modest risk-on position via equities. However, the team remains negative on duration given the stronger cyclical growth and inflation outlook, especially in the US as the economic re-opening and the impact of fiscal easing draw nearer. Today’s meeting reinforces this stance as the Fed stands pat, while the risk of tantrums remains live, given the lack of additional tangible action from the Fed.