U.S. Federal Reserve leaves policy unchanged amid improving economic conditions

U.S. Federal Reserve leaves policy unchanged amid improving economic conditions

*At the conclusion of this week’s FOMC meeting, the Fed announced that it will maintain its current monetary policy—zero interest rates and the recent pace of purchases of Treasuries and MBS ($80 billion and $40 billion, respectively)—while characterizing economic conditions as improving and inflation rising largely to reflect transitory factors.

*The Fed emphasized in its Policy Statement that it is committed to extending its current monetary ease until “substantial further progress has been made toward the Committee’s maximum employment and price stability goals.” In his press conference following the FOMC meeting, Chair Powell emphasized that the economy is far from full employment.

*In sum, the Fed provided no new information on its future conduct of monetary policy, and left open many unanswered questions in the rapidly changing environment. Based on our projections of strong economic growth and a moderate rise in inflation involving more than just temporary factors, we expect that the Fed will announce in late summer-early fall that it will begin tapering its asset purchases beginning in early 2022, with the understanding that it will begin to lift its policy rate target ever-so-slowly beginning about a year later.

The Fed’s description in its Policy Statement that indicators of economic activity have strengthened and the sectors most adversely affected by the pandemic “remain weak but have shown improvement” is consistent with its forecast of robust growth provided in its March Summary of Economic Projections (SEPs).

It is important to note that while the Fed forecasts real GDP growth of 6.5% in 2021 (Q4/Q4) and 3.2% in 2022, it forecasts that labor market improvements will lag. While real GDP will exceed its pre-pandemic level by Q2’2021, employment through March remained 8 million below its pre-pandemic level. Moreover, the Fed’s new strategic framework has refocused monetary policy on shortfalls from its objectives of maximum inclusive employment. This means the Fed will aim to drive the unemployment rate below its estimate of sustainable full employment and will be scrutinizing employment and labor force participation patterns of disadvantaged groups, as well as aggregate labor market measures.

The Fed’s statement, “Inflation has risen, largely reflecting transitory factors” (italics added) suggests a possible change in Fed tone: that maybe some of the rise in inflation in March and expected in coming months’ reports may not be fully attributable to the base adjustment from the monthly declines recorded in spring 2020. But that has no bearing on near-term policy, as the Fed favors inflation rising above 2%. The Fed’s statement is simply consistent with a rise in market-based measures of inflationary expectations, high production costs and mounting anecdotal evidence that businesses are raising product prices in an attempt to maintain their margins.

There are several bigger issues beyond any nuanced near-term interpretation of this week’s FOMC meeting. Will the Fed change its tune when the economy shifts into high gear, as it forecasts, and there is clearer evidence that a more-than-just-temporary rise in inflation may be unfolding? If inflation pressures do mount, will the Fed delay any monetary tightening, either because it is committed to an overheated economy that is necessary to generate maximum inclusive employment, or because it doesn’t want to jar markets? This would have longer-run negative consequences. Or will the Fed normalize policy, which may involve short-term pain but pay off in the longer run? These issues will make the remainder of 2021 interesting.

Mickey Levy, mickey.levy@berenberg-us.com

Member FINRA & SIPC
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