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Written by: Eric Winograd
Last Wednesday, the Federal Reserve responded to stubborn inflation pressures in the US economy by doubling the pace at which it’s tapering its QE purchases. It also ramped up the number of rate hikes it expects will be needed to bring the economy back into equilibrium in the medium term.
Neither development particularly surprised markets, but this shouldn’t obscure the magnitude of the changes compared with expectations only a few weeks ago. Instead of a fixed, gradual taper ending in mid-2022, we now have an accelerating, rapid purchase reduction wrapping up in March. Rather than debating whether to raise rates in late 2022 or early 2023, the Fed will now debate a rate hike within the next three months.
A Big Change in the Fed’s View on COVID-19 Impact
Those are big changes reflecting a big change in the Fed’s view of COVID-19’s likely impact on the US economy. A year ago, the Fed and most forecasters, AB included, saw the pandemic as primarily a demand shock that would probably impair growth.
Now, however, COVID-19 seems primarily a supply shock that instead is pushing inflation higher. Because risk management is the name of the game for monetary policy, that change in risk outlook warrants a change in the policy stance. That’s exactly what the Federal Open Market Committee (FOMC) has moved toward over the last few months—and emphasized today.
Rate Hikes Soon…but Not Necessarily an Aggressive Cycle
We expect the Fed to raise rates for the first time in March 2022, following with hikes in June and September before pausing in late 2022. The FOMC is trying to manage the risk of higher inflation lasting into the second half of next year. Because monetary policy works with a lag, a Fed worried about persistent inflation into the second half of 2022 needs to raise rates earlier, not later.
We’re still not convinced that a lengthy, aggressive cycle of rate hikes will be necessary. Inflation remains very likely to moderate on its own as COVID-19 distortions fade, and we see little evidence from market-based indicators of inflation expectations that the Fed’s credibility is in jeopardy. Survey-based measures of inflation expectations have climbed, but not in an alarming way, suggesting that the Fed has enough room to maneuver and can afford to be patient if the economic outlook warrants it.
Growth and Inflation Likely Slower in Second Half of 2022
By the second half of next year, we expect growth and inflation to be meaningfully slower than today, making the need for more rate hikes less obvious. Our initial expectation for 2023 is one to two rate hikes—not the three indicated by the new Fed dot plot.
While that might sound pessimistic, we don’t think it is. If a small number of rate hikes is enough to return the US economy to sustainable levels of growth and inflation, they should pave the way for a longer, more durable expansion. If, instead, the FOMC needs to raise rates more aggressively, the risk to the economy and financial markets would rise substantially. Next year should be challenging for both of them, but not a disaster, in our view.
The Labor Market Is Key to the First Rate Hike
The FOMC was clear that inflation it has met the inflation side of its mandate, so the committee will raise rates as soon as it feels the economy is at full employment.
But what is full employment? That’s a topic we’ll be monitoring very closely in the coming weeks. In this case, monitoring doesn’t necessarily mean watching the data--it means watching the evolution of the Fed’s thinking about the labor market. There is no one single measure of full employment, as Chair Jay Powell reiterated yesterday. Over the past few months, he’s referenced several benchmarks, but the balance between them is fluid and open to interpretation.
That fluidity means that the state of the labor market will be a key cog in FOMC discussions in coming weeks. If the Fed concludes that labor force participation will likely stay below precrisis levels, retirements will likely keep accelerating and retail employment is unlikely to rebound, among other factors, it would suggest that the US economy will likely reach full employment at a lower total employment level, making rate hikes imminent. To be clear, we expect this to happen.
That said, the data do matter—at least to a degree. Three payroll reports arrive between now and the Fed’s March 2022 meeting. The numbers don’t need to be strong to trigger a March rate hike; unless they’re particularly weak, a rate hike will probably happen. “Weak,” in this context, doesn’t mean below market expectations. Instead, it means a number suggesting that the labor market is no longer tightening. Unexpected inflation relief could also slow the march toward higher rates.
COVID-19 Could Undermine Full Employment
If the US economy falls short of full employment, the COVID-19 pandemic will be the likely culprit. This scenario isn’t our base case—nor the Fed’s—but the pandemic has taught all of us to be humble in mapping a path for COVID-19.
If the virus situation worsens in a way that slows the economy significantly—and progress toward full employment with it—the Fed’s expectations for 2022 will be wrong. So, as much as we might like to, we can’t yet dismiss COVID-19 from our economic outlook. In that sense, at least, the start of 2022 will look similar to the start of 2021. Hopefully, by 2023 that will no longer be the case!