"And they will not control us..."
- Muse, Uprising
Last week we argued that the European Central Bank (ECB) President had failed to effectively communicate the meaning – and therefore market relevance – of the ‘favourable financing conditions’ anchor in the monetary policy narrative. We further argued that, ultimately, if effectively communicated it potentially bridges the gap between a need for further monetary accommodation and a lack of appetite for either a more negative deposit rate or a bigger PEPP envelope from the Governing Council. In essence an enhanced (dovish) forward guidance. This week it was the turn of the Federal Reserve (the Fed).
The Fed’s undefined monetary policy anchor is the ‘substantial further progress’ narrative – attainment of which paves the way (after significant advance market communication) to the tapering of the Fed’s asset purchases and thus the first step towards monetary normalisation. The Fed Chairman made it clear that the Fed will not define ‘substantial further progress’ at least until, in the Fed’s subjective view, it has already been attained. In my view, this simple point sums up the Fed’s policy stance at the current juncture - reactive, not proactive and conscious to err on the side of caution.
All about growth
This week’s Fed meeting brought no change to rates or to the asset purchase pace. Indeed, there were very minimal changes to the statement between January and March except for an upgrade to the language describing the current economic activity and labour market dynamics (and by extension marginally upgrading the aggregate demand impact on inflation). The major change, and the reason that this meeting had become such a focal point of late, was the upgrade to the Summary of Economic Projections (SEPs or ‘dots’). An upgrade to take account of the vaccine and reopening progress and the significant impact of two huge fiscal stimulus packages passed by congress (totalling ~14% of GDP) since the last SEP round in December 2020.
Going into the meeting the market was comfortable with its bigger stimulus = higher growth view and, therefore, with a significant upgrade in the SEP growth estimates as well as higher inflation forecasts and lower expected unemployment (through each of the next three years).
The focal point, however, was how the stimulus impact on inflation would affect the Fed’s (individual) expectations of rate hikes. More clearly, what does the expected level of (PCE) inflation in 2023 tell us about the propensity of the Federal Open Market Committee (FOMC) to raise rates in 2023? The thinking ahead of time was that a relatively low PCE (say 2.1%) at the end of 2023 and a (median) expectation of a rate hike in the same period suggests the Fed has a relatively hawkish reaction function, i.e. a relatively modest inflation overshoot would warrant a rate hike – this seems unlikely given the AIT framework.
Despite higher inflation forecasts and huge upgrades to growth and unemployment, what we got was a median PCE inflation estimate of 2.1% in 2023 and dots still showing no hikes. Furthermore, the Fed Chairman pushed back on the process of focussing on the ‘dots’, stating that the individual forecasts or dots (with non-uniform uncertainty and assumptions) do not represent the median view of the FOMC and that the dots were not discussed in terms of the current policy response. The dots do, however, likely provide a welcome dovish message from the Chairman’s perspective.
Indeed, even in response to the more pressing issue of the potential timing of the tapering of asset purchases, the Chairman emphasized that the ‘substantial further progress’ the FOMC wants to see before tapering is “actual progress, not forecasted progress,” and reiterated that the Committee will provide “as much advance notice of any potential taper as possible.”
The reaction function of the Fed, so far at least, appears to be not to react. Not to react to forecast inflation pressure at the end of ‘23 in the dots, not to react to markets driving the US yield curve higher on acute reflation expectations, not to react to calls to quantify ‘substantial further progress’ – at least as far as to suggest that the Fed will remain reactive, not proactive.
There are however a couple of reaction functions that are perhaps worthy of closer note over coming months (until the June SEPs).
Firstly, markets are likely to pay close attention to the reaction function of risk assets to further rises in long end US rates. Our view remains that the rise in US yields (even long- term funding costs) remains below the level of growth and thus can remain supportive for equities – provided the rate of change of yields remains modest. This is also a key variable for emerging markets.
Secondly, over coming weeks and months, as was alluded to by the Fed Chairman in the press conference, “really strong economic data is coming”. From our perspective the reality of sharply higher US economic data will underline the divergent growth trajectories and thus is likely to generate a heightened reaction function in FX.
Lastly, while the focus on rising US yields is unlikely to go away in the near term, it is likely that the correlation of global bond markets remains. Further, as the US growth surge plays out it will further reaffirm the case for higher US yields. In countries where the current growth impetus is weaker, virus trajectory more negative or inflation prospects weaker (or all three) there is potentially a higher reaction function between US yields and foreign central banks- with the ECB an obvious case in point. Higher US yields have forced the Fed to resist more hawkish pressures from the market (and have thus characterised themselves as dovish). However, higher US yields are likely to put pressure for a more activist dovish response from the Fed to prevent an undue tightening on financial conditions – or in their words retain ‘favourable financing conditions’.
For now at least the Fed remain resolute in the face of the reflationist uprising. What may be more interesting going forward however is the not so direct reaction functions across global markets.
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