Still transitory: U.S. Fed maintains stance on inflation, announces start of tapering
There were two main takeaways from Wednesday's U.S. Federal Reserve (the Fed) policy meeting. First, the Federal Open Market Committee (FOMC) announced it would taper its asset-purchasing program, otherwise known as quantitative easing (QE), that has been in place since the pandemic began. This was widely expected. Second, the committee reiterated its baseline that the inflation overshoots hitting the U.S. economy right now are expected to be transitory. The latter was the more consequential development for markets, as investors have grown anxious about the Fed’s resolve as inflationary pressures build and other central banks have pivoted in a more hawkish direction.
Why tapering matters
Chair Jerome Powell and the Fed had been holding the market’s hand in the lead-up to the tapering decision, making it abundantly clear that a decision was imminent at the November 3rd meeting and effectively pre-announcing all of the relevant details of the decision (pace, composition, timing, etc.).
Quantitative easing—and by extension, tapering—is most impactful in providing forward guidance about the future path of interest rates. Asset purchases provide additional stimulus when policy rates are constrained by the zero lower bound. It is highly unlikely that a central bank would ever buy assets (providing accommodation) at the same time as it is hiking rates (removing accommodation). As such, only once QE has ended does the door open for the first rate hike. Based on the current tapering pace and plans, QE will end in June 2022. Barring major surprises to the outlook, June 2022 should be judged as the absolute earliest date for liftoff.
Whether the Fed actually hikes interest rates in 2022 will hinge on future economic conditions, chiefly the status of the labor market and inflation. Specifically, the Fed will be looking at:
- Whether the labor market will be at full employment, which is generally considered met when the unemployment rate falls to 4% (we think it will, based on very strong labor demand)
- Whether inflation will be at 2% at that time, and whether future expectations are for inflation to exceed the Fed’s 2% target.
Inflationary risks in the U.S. have been building. Supply-chain issues have intensified. Wage inflation has shot up. Shelter inflation has shot up. And measures of the breadth of upside inflationary pressures have also increased. That’s quite concerning in the short-term, of course, but the question for policymakers is more about where inflation will be in the second half of next year (when the door opens for liftoff) than where it is right now. If inflation holds above 2% and is expected to stay there, we believe the Fed will hike. If inflation drops back below 2%, we believe the Fed will hold at zero.
That inflation forecast is subject to considerable uncertainty. The Fed has the luxury of waiting until mid-2022 to assess how conditions evolve. In our view, there are several factors that could moderate U.S. inflation dynamics over time:
- Moderating demand
The U.S. economy was supercharged by the CARES Act, the American Rescue Plan and other fiscal stimulus measures that collectively are only rivaled by the U.S. government’s responses to World War I and II. These stimulus measures bolstered household income (which grew sharply through the recession) and spending power. Those tailwinds are now largely in the rearview mirror. Household savings are high, but now held predominately by the wealthiest Americans, who have a lower propensity to spend. The impacts of the infrastructure bills under negotiation in Washington, D.C., are scheduled to be spread over a decade and don’t move the needle meaningfully.
- Demand rebalancing from goods to services
Consumer demand for goods (electronics, furniture, etc.) spiked following the crisis and lockdowns. Spending on goods is continuing to run well above pre-COVID norms. It seems reasonable for demand to rebalance toward socially-facing service activities (restaurants, sporting, travel) as vaccines become more broadly available and virus concerns eventually moderate. The goods sector has been pushed beyond its capacity constraints while the services sector still has room to recover and grow. Such a rotation to where there is still slack in the economy should ease inflationary pressures.
- The slowdown in China
My colleague Alex Cousley thinks that real GDP (gross domestic product) growth in China could slow to 5% or less in 2022 as the property sector—which drives 25% of economic activity in China—goes through a challenging deleveraging phase. China is a key demand driver for commodity markets, particularly in the industrial metals segment. The inflationary risks from China are admittedly two-sided, however, as a COVID outbreak in the country that disrupts production and trade could further strain global supply chains. We view these risks as skewing disinflationary over time.
Supply-chain bottlenecks create profitable opportunities for companies to invest in capacity to meet demand at today’s higher prices. Indeed, a range of business surveys show robust capital-expenditure intentions from the manufacturing sector in the near-term. As an example, the global semiconductor industry is on track for its biggest year ever for new investment in semiconductor fabrication facilities and equipment. Many of these investments will take some time to bear dividends, but the process of building out supply to meet demand is well underway.
- Secular disinflationary forces
One of the most unusual features of the post-COVID high-inflation regime has been in the prices of consumer durables. This has been an area of secular deflation for the 25 years leading up to the COVID pandemic. Think about how the price of a high-end television has evolved over the decades. In 1997, Philips unveiled the first flat panel television. It was groundbreaking. It cost US$15,000. And the resolution was not high-definition, let alone 4k or 8k. That television (abstracting from nostalgic value) would be worthless today. That’s deflation, and our expectation is that many of these trends should reassert themselves again over time.
The U.S. inflation outlook is highly uncertain. We compare our own inflation models and forecasts, probabilistically, against what is priced in the market. Could the Fed hike in 2022? Yes. Do we assign a 95% probability to this outcome? No. We think the risks are skewed to a slower tightening profile in the short-term than what is currently discounted. That should allow yield curves to re-steepen. It should also allow securities that are sensitive to U.S. interest rate dynamics (like value equities) to have another leg of outperformance.
More broadly, we continue to think that the economic outlook is supportive for risk markets over the medium-term. The economic recovery is clearly maturing. U.S. real GDP is already 1% above its pre-COVID peak and S&P 500 earnings are already 25% above their pre-COVID peak. But an accommodative Fed and a lack of major macroeconomic imbalances suggests to us that recession risks remain lower than normal at present. Staying invested is a simple but powerful discipline, particularly when cash yields zero and the purchasing power of cash is being undercut by unusually strong inflation risks in the short-term.