Fed’s hawkish tilt is just the start says Schroders Chief Economist

The latest meeting of the Federal Open Market Committee brought no change in policy settings, but a clear and in our opinion timely tilt toward tighter policy in the future.

There was little change in the accompanying policy statement, except that the Federal Reserve (Fed) does seem to be acknowledging that Covid-related downside risks have been reduced by the vaccination programme’s progress.

The focus of the statement released following the two-date FOMC meeting was very much on the Fed’s economic projections and the “dot plot”, its chart representing the interest rate forecasted by 18 members of the committee.

Upgrades to the growth and inflation forecasts for this year were not a surprise, but the increase in the number of FOMC members looking to raise interest rates by the end of 2023 did catch the markets off guard.

The median dot for the end of 2023 moved up to 0.625%. Consensus going into the meeting was that there would be no change from current levels. There was also a noticeable increase in the number expecting higher rates by the end of 2022, although the median dot remained unchanged on this time horizon.

In his press conference, chair Powell acknowledged that the committee was now “talking about talking” about tapering and “the possibility that inflation could turn out to be higher and more persistent than we expect” given the bottlenecks in re-opening the economy.

The Fed’s projections make clear that the pick-up in inflation is seen as transitory, but there has been a significant shift in expectations for this year following recent data.

These moves bring the Fed closer to our own projections, where we forecast that the central bank will begin tapering at the end of this year and raise rates at the end of 2022.

Our view is driven by the strength of growth we are likely to see in the second and third quarters of this year and an ongoing positive outlook. This means we have concerns that the economy will be heading for higher inflation even if the current pick-up proves transitory.

We do expect inflation pressures to ease later this year but then to rise again in 2022 as the output gap closes and the economy overheats. The Fed will find it difficult to be passive in this environment and will have to act to prevent a significant rise in inflation expectations, which of course would feed a sustained rise in inflation through stronger wage growth.

ENDS