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.