Fed minutes show that most members still view the risks to inflation as weighted to the downside

The minutes to the January 26-27 FOMC meeting emphasized Fed members’ comfort with the current zero percent interest rate policy and massive purchases of Treasuries and mortgage-backed securities. The Fed made a deliberate effort to highlight several times in the minutes that “economic conditions were currently far from the Committee's longer-run goals and that the stance for policy would need to remain accommodative until those goals were achieved.” Members acknowledged that medium-term prospects for the economy had improved because of vaccines and the high likelihood of additional fiscal stimulus. They stressed that it was important to “abstract from temporary factors affecting inflation” when determining whether inflation is on track to moderately exceed 2% for some time. Interestingly, most members still view inflation risks as weighted to the downside.

Fed members’ relatively downbeat views on current economic conditions at the January FOMC meeting are stale. Incoming data suggest that economic activity is off to a robust start this year, boosted by the second round of government income support checks to households and the easing of the pandemic (US retail sales surged in January as households received income support checks, February 17, 2021). Downside risks to the outlook mentioned by the Fed include: 1) new virus strains; 2) vaccine hesitancy from the public; and 3) potential difficulties in vaccine production and distribution. Upside risks include: 1) more expansionary fiscal policy than expected; and 2) households spending a greater share of their accumulated savings than anticipated.

The Fed will publish its next quarterly Summary of Economic Projections (SEPs) at its March 16-17 FOMC meeting. We expect Fed members to revise up their forecasts of real GDP and inflation, and expect more—close to a majority—to forecast that it will be appropriate to raise the Fed funds rate in 2023. Actual growth has persistently exceeded the Fed’s expectations throughout this recovery and its new forecasts will reflect the fiscal stimulus enacted in December and the expected additional stimulus under the Biden Administration. Our forecast for 2021 real GDP (Q4/Q4) growth of 6.9% is far above the Fed’s median forecast of 4.2% in its December SEPs (Already strong U.S. economic growth outlook revised up further and Strong U.S. growth, inflation and the Fed’s challenges).

Against the backdrop of economic strength, we expect the Fed to announce in late summer or fall, that it will begin tapering its asset purchases in early 2022. Markets will take that as a signal that rate hikes will eventually follow.

The Fed’s new strategy focuses on maximum inclusive employment. According to the minutes, members observed that “even with a brisk pace of improvement in the labor market, achieving this goal would take some time.” So expect the Fed to maintain its ultra-easy monetary policy as long as labor markets are recovering and inflation remains moderate. We expect the labor market recovery to lag the economic recovery, but there is a lot of uncertainty around the trajectory of inflation. Inflation will temporarily jump in Q2 due to base effects from the declines in prices in March and April 2020. After that, we expect inflation to rise on a more sustained basis. Whether any acceleration in realized inflation is actually sustained will depend on aggregate demand and inflation expectations.

Roiana Reid, roiana.reid@berenberg-us.com

Member FINRA & SIPC
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