Whiffs of the long-awaited “taper talk” around US monetary policy are finally in the air. The Federal Open Market Committee’s (FOMC’s) June 2021 statement and press conference indicated that the FOMC has discussed when it ought to start tapering its large-scale asset purchases amid the ongoing economic rebound and mounting inflationary pressures.
The FOMC upgraded its US growth and inflation forecasts, yet kept its unemployment rate forecast unchanged, as labor supply shortages in an environment of strong consumption are leading to higher inflation than the FOMC previously anticipated. The increasing inflationary risks also resulted in the median FOMC participant now expecting to hike interest rates twice during 2023. US Treasury yields rose across the yield curve following the release of the FOMC’s revised summary of economic projections, led by the 5-year Treasury note.
Mounting inflationary pressures
Lingering supply bottlenecks, growing supply pipeline costs, and rising unit labor costs are all helping to push US inflation upward. Meanwhile, demand-pull pressures are intensifying, fueled by the unleashing of pent-up consumer and business demand as the US economy continues to reopen and recover from the severe COVID-19 shock.
The May Consumer Price Index (CPI) release showed core domestic inflation rising 3.8% year over year, while the US Federal Reserve’s (Fed’s) preferred inflation gauge — core personal consumption expenditures (PCE) — rose at a more modest 3.1% through the end of April, still well above the central bank’s 2% target for average long-term inflation.
Recent Fed speakers, including Chair Jerome Powell, had thus far shrugged off elevated inflation prints, contending that inflationary pressures should prove transitory, warranting a “wait-and-see” approach to removing policy accommodation. Against this backdrop, today’s more hawkish policy-rate projections suggest that recent upside inflation surprises have begun to accelerate the Fed’s previous timeline, which was based on its flexible average-inflation-targeting regime.
I think of the Fed’s new framework as similar to a “make-up” strategy whereby recent increases in broad inflation have been large enough to make up for several past years of inflation shortfalls, even if the individual components are not necessarily likely to signal a persistent inflation trend.
Details of the CPI release indicated rising prices for several inflation components that are most exposed to the combination of global supply disruptions and growing domestic demand. There were also signs that domestically generated core services inflation is rising sharply, which tends to be sustainable. However, I expect some of the components that contributed most to this sharp increase — prices for hotel stays and used autos, for example — to moderate in the coming months as supply and demand become more balanced. Importantly, the largest component of both the CPI and PCE — owners’ equivalent rent — has been relatively stable throughout the pandemic and subsequent recovery.
Possible timing of tapering
There remains substantial uncertainty regarding the pace and extent of overall US inflation, given the volatility of economic data releases as the nation’s economy reopens. My bias is that overall inflation should subside somewhat in the coming months, but that some components will prove more enduring than the Fed expects, thereby testing the Fed’s patient resolve to maintain its policy accommodation.
Chair Powell acknowledged in yesterday’s post-meeting press conference that tapering discussions have begun to take place among FOMC members. While economic conditions do not yet (in my view) call for tapering of the Fed’s asset purchases, I think the central bank will likely be prepared to begin scaling back its purchases in the fourth quarter of this year.
I favor maintaining a shorter-duration bias in fixed income, concentrated in the five- to 10-year part of the yield curve. I also believe the US Treasury curve could flatten from here. At some point, if yields climb higher, I would expect buyers to step into the Treasury market in larger numbers, particularly given the attractiveness of US Treasury yields to overseas investors on a foreign-exchange-hedged basis. The US rates market has proven surprisingly resilient considering the strength of economic data and upside inflation surprises.