Well Fed

by | June 21, 2021

This past week, the Fed delivered a jolt to markets. We saw it coming, but just not quite yet. 

On Wednesday, Chairman Powell and his Federal Open Market Committee (FOMC) members surprised markets with what can only be described as a ‘mea culpa’. After months of asserting without much doubt that inflation would be ‘transitory’, the Fed caught observers offside with an admission that inflation risks are, apparently, more evenly distributed.

Of course, that’s not how the FOMC statement put it, nor how Powell parsed it in his ensuing press conference. But by raising their core inflation forecast from 2.2% to 3.0% and bringing forward the ‘dot plot’ of expected future Fed funds rate hikes from 2024 to 2023, the Fed made it abundantly clear that it isn’t quite as certain about US inflation dynamics as it might have been before. 

The market reaction was swift. For those engaged in ‘reflation trades’, it was also brutal. Intermediate maturity bonds sold off, reflecting expectations for Fed tightening sooner than had been expected, while longer maturity bonds rallied as expected inflation and future growth rates were dialed back. Cyclical sectors and styles were dumped in favor of more defensive growth companies. The dollar rallied and commodity prices slumped. 

In short, the Fed’s change of tone swung markets away from euphoria about higher nominal GDP to the sobering possibility that the Fed will have to tap the brakes sooner than previously thought to prevent the economy from overheating.

While it is tempting to conclude that the Fed has now jettisoned the pledge it adopted only last year to permit inflation to overshoot its 2% target, the reality is a bit more nuanced.

By shifting its rhetoric, the Fed did itself a favor. The Fed is fallible. Its forecast track record is replete with misses. It was never wise to be so confident about benign future inflation outcomes. 

The Fed also introduced some fear into markets where hitherto little was to be found. Removing froth from markets makes sense, especially now that the economy is on a firmer footing. Minor setbacks in financial markets won’t pose much risk to a recovery in the real economy that has a full head of steam. It makes sense for the Fed to both acknowledge stronger growth—as it did by raising its forecasts to 7% real GDP growth this year and 3% next year—and to introduce some doubt about how long it will remain committed to super-expansionary policies.

The focus now shifts to Chairman Powell’s testimony to Congress this week on the Fed’s response to the pandemic. That forum will provide Powell with an opportunity to clarify the Fed’s position on when it foresees removing emergency measures adopted over the past year, as well as to answer questions about the Fed’s shifting views on inflation. In particular, Powell may be asked to elaborate on supply bottlenecks in product and labor markets, how long they may last and what can be done to nurture the supply side of the economy.

About the Author

Larry Hatheway has over 25 years experience as an economist and multi-asset investment professional. He is co-founder, with Alexander Friedman, of Jackson Hole Economics, LLC, which offers commentary and analysis on the global economy, policy & politics, and their broad implications for capital markets. Prior to co-founding Jackson Hole Economics, LLC Larry worked at GAM Investments from 2015-2019 as Group Chief Economist and Global Head of Investment Solutions, where he was responsible for a team of 50 investment professionals managing over $10bn in assets. While at GAM, Larry authored numerous articles on the world economy, policy-making and multi-asset investment strategy.

Larry was also the lead investment manager for various mandates, funds and an actively managed multi-asset index. Larry also served on the GAM Group Management Board, was Chairman of the GAM London Limited Board and served as member of the GAM Investment Management Limited Board. Larry was also Chairman of the GAM Diversity & Inclusion Committee. During his tenure at GAM, Larry was based in London, UK and Zurich, Switzerland.

From 1992 until 2015 Larry worked at UBS Investment Bank as UBS Chief Economist (2005-2015), Head of Global Asset Allocation (2001-2012), Global Head of Fixed Income and Currency Strategy (1998-2001), Chief Economist, Asia (1995-1998) and Senior International Economist (1992-1995). During his tenure at UBS, Larry was also a standing member of the UBS Wealth Management Investment Committee. While at UBS, Larry worked in Zurich, Switzerland, London, UK (various occasions), Singapore and Stamford, CT.

At both GAM Investments and UBS Investment Bank Larry was widely recognised for his appearances on Bloomberg TV, CNBC, the BBC, CNN and other media outlets. He frequently published articles and opinion pieces for Bloomberg, CNBC, Project Syndicate, and The Financial Times, among others.

Before joining UBS in 1992, Larry held roles at the Federal Reserve (Board of Governors), Citibank and Manufacturers Hanover Trust. Larry Hatheway holds a PhD in Economics from the University of Texas, an MA in International Studies from the Johns Hopkins University, and a BA in History and German from Whitman College. Larry is married with four grown children and a loving Cairn Terrier, and resides in Wilson, WY.

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