Natixis IM: Our take on the Fed

Natixis IM: Our take on the Fed

Fed
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By Jack Janasiewicz, CFA Portfolio Manager and Portfolio Strategist Portfolio Research and Consulting Group

What does that mean?  We’ve seen the forecast for GDP revised higher, unemployment revised lower, inflation revised higher.  And yet the median dot (member forecast) for rates remain unchanged.

Otherwise said:  Expectations for better growth with lower unemployment and higher inflation while keeping interest rates unchanged is modestly dovish.

What to think about?  December of 2020 saw 16 of 17 members forecasting to keep rates unchanged for 2022.  Those numbers shifted yesterday with 14 of 18 members expecting no change.

So that means:  4 members are now forecasting a hike in 2022, up from just 1 in the December 2020 forecasts.  

For the 2023 expectations, the December 2020 forecasts had 5 of 17 members calling for a rate increase.  Today, that shifted to 7 of 18 members – an increase of 2 more members expecting a hike in 2023.

Importantly, these shifts were not enough to change the median expectation which still calls for rates to remain on hold throughout 2023.  We do take note that a few members seem to be getting a little uncomfortable with the outlook however. 

The question though – who’s dots are those that shifted?  Non-voting members – so not as relevant?  And if they were voting members - can Powell get them on board with his thinking and the new policy framework?

So what?  So herd cats.  There is plenty of time for Chair Powell to get others on board with the average inflation targeting framework.  We’ll be watching to see the evolution of this management of the governors.

What else made us go hmmm?  The wide end of the core Personal Consumption Expenditure (PCE)forecast for 2021 hit 2.5% according to the Fed’s economic projections.  That number comes down to 2.3% for 2022 and 2023.

This implies that inflation will top out at 2.5%.  Is this because inflation will prove to be transient or that the Fed will hike to put a lid on this?  The projections leave us wondering.

But after all they’re just projections. The real measuring stick for policy decisions is actual progress not forecast progress.

Chair Powel continues to stress the uneven recovery.  What does this mean?  The Fed has a dual mandate:  price stability and full employment.  

Given his comments today and comments in previous speeches as well as sentiment echoed by former Fed Chair now Treasury Secretary Yellen, the latter seems to be taking a bit more precedence.  

Full economic employment is one way in which the Fed can attack the issue of income inequality, a key theme espoused by the Biden administration.

We’ve heard from Powell about several key indicators in terms of quantifying this inequality:

Black unemployment 

  • Pre-pandemic (Feb 2020):  6.0%  
  • Currently: 9.9%

Low wage earners wage growth (bottom 25% quartile)   

  • Pre-pandemic (Feb 2020):  +4.7%
  • Currently:  +4.0%
  • Previous downturns have taken an average of 3 years to recover

Labor force participation rate for those without a college education

  • Pre-pandemic (Feb 2020):  58.3%
  • Currently:  54.7% (lowest since data has been recorded)

We are very far from meeting these key indicators in terms of meeting the full employment mandate.  And it’s going to take quite some time for these gaps to close.

Large gains have and will likely continue to be made quickly, but removing that final bit of labor market slack can prove more challenging.

Particularly as business restructure to become leaner and more efficient resulting in potential frictions for re-employing those who have lost jobs.

Hiking rates too soon could very well leave these gaps well short of what would likely be seen as an acceptable economic recovery.  

The market continues to hear what it wants to hear.  This continues to be a head scratcher.  Powell continues to stress that he is now data driven.  Not pre-emptive.  

Models are out.  Actual inflation is in.  Full employment could very well be priority one while price stability takes a back seat.  

Remember, the Fed wants 3 things to happen before they hike:  

1.       Full employment 

2.       Actual inflation above 2%

3.       Inflation forecasts calling for inflation to be > 2% for a persistent time

We are far from checking the box on any of these things.  And yet the market continues to want to “test the Fed’s resolve.”

Maybe once – just once – the market will actually take Powell at his word.  Because he’s been saying what he plans to do since the day he took the seat as Fed Chair.

Yet the market thinks otherwise.

What about the markets?  The stealth easing probably means higher equities and a steeper curve.

The market will continue to doubt the Fed.  And this means inflation expectations will continue to rise.

Firming inflation this year will only add to this despite well-known base effects and emerging and resolving supply/demand imbalances.

But at some point, the market will need to stop extrapolating the current trends into infinity.

Just remember, financial conditions matter more.  It’s not just about rates.  Financial conditions are all-encompassing, not narrowly defined by nominal rates.    

And financial conditions have continued to ignore the rise in nominal rates.  They remains extremely loose.  Extremely accommodative.