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Fed to keep policy easy despite arrival of economic boom
Evidence continues to mount that a combination of vaccinations and stimulus are creating some of the strongest economic growth data in decades. Even so, the Fed remains committed to easy monetary policy until unemployment falls further and inflation materializes.
The U.S. Federal Reserve’s Open Market Committee (FOMC) made little new news at its April meeting, as expected. The Fed upgraded its assessment of the U.S. economy, but remained resolutely dovish in its language on the policy outlook from here. It did not budge from its long-standing promise to keep interest rates low until it becomes convinced that the effects of the pandemic have fully receded.
The statement accompanying the decision removed language in previous statements that referred to the economic risks of the pandemic as “considerable.” It added that “indicators of economic activity and employment have strengthened,” a nod to the robust March jobs report and retail sales figures.
Chair Jay Powell repeatedly emphasized that the Fed would not reduce its current asset purchases until “substantial further progress” had been made toward full employment and the Fed’s 2% inflation target. He added that he did not anticipate that these benchmarks would be met any time soon. The threshold for interest rate increases is even higher and will take longer to meet.
Boom? What boom?
The data we’ve received since the Fed’s last meeting suggest that the economic reopening boom has arrived. Consensus expectations for U.S. GDP growth continue to rise. The International Monetary Fund, for example, recently revised up its 2021 U.S. growth forecast to 6.4%. Just six months ago, it was predicting 3.1%. We described this in our Nuveen Q2 Outlook as “the upside scenario.”
The Fed has maintained a consistent policy stance throughout a period of sharp improvement in economic expectations among investors, consumers and economists. While it acknowledges the improvement – revising up its own growth and employment forecasts in March – it has not reacted to good news by even hinting that tighter policy is on the way.
During the previous cycle, the Fed began to remove accommodative policy – quantitative easing, zero interest rates – as the economy slowly improved and their forecasts pointed to higher inflation just over the horizon. This time, the Fed has made it clear that it will not move policy based on forecasts, but will instead react to actual inflation data. So the question for investors is quite simple: When will higher inflation show up, if it hasn’t already?
Inflation is on the rise...for now
We’ve been warning investors for months that the spring would bring higher inflation numbers, and so it has. The cumulative rise in energy prices over the past year has caused year-on-year price increases to accelerate. The Fed acknowledged this in its statement, while also arguing that it “largely reflect[ed] transitory factors.”
We agree that the inflation “bump” over the summer will be temporary. March Consumer Price Index (CPI) data showed reflationary trends in distressed industries like hotels, travel and leisure, but prices in these areas are still generally lower than they were one year ago.
As demand returns – swiftly and suddenly – to dormant segments of the U.S. economy, companies may find their supply chains stretched and good labor hard to find. This makes a material rise in prices over the summer a distinct possibility. But this type of inflation – a response to a one-time demand shock – would be less worrisome to the Fed than a genuine wage-price spiral that forces it to slow credit creation through reduced liquidity and higher interest rates.
Still a long runway for investors
We continue to advise investors who are concerned about inflation to consider allocating more to economically sensitive asset classes like U.S. small cap stocks and real estate. While neither provides the explicit inflation compensation that U.S. Treasury Inflation Protected Securities (TIPS) do, they are likely to perform better in an environment in which both growth and inflation are rising. The rise in long-term interest rates has paused for now, but we expect the U.S. Treasury yield curve to steepen between now and the end of the year, favoring cyclical areas of the market, including banks.
We see quarterly GDP growth rates peaking in the second quarter and remaining strong over the balance of the year, supporting higher corporate earnings growth and greater investor risk appetite. Stronger growth alone will not bring the Fed off the sidelines, however. We expect asset purchases to begin winding down in the first quarter of 2022 and interest rate increases to start no earlier than the second half of 2023, well past what the market is currently pricing in. This should mean investors should enjoy at least a few more years of loose financial conditions before the environment becomes tighter.
Federal Reserve Statement, April 2021.
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A word on risk
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