While the March FOMC meeting brought only minor changes to their forecasts and statement, it did offer some interesting tidbits, and surprises, too. Starting with the headliner—Jerome Powell—we have a new Chair, who brought perhaps a bit less academic, less deliberative delivery in the press conference. In terms of the substance though, the message was very similar to what it’s been: in their best estimation, a slow and steady stream of rate hikes will be needed in the years ahead to keep the economy on an even keel. Interestingly, while their statement acknowledged some mixed recent economic data, they nonetheless—presumably to some degree the result of the fiscal stimulus in train—on the margin boosted their projections for growth, the path of the funds rate, and inflation.
Deciphering the Forecasts
The Chair engaged in the usual battle to move the focus of the Q&A away from their projections and back to reality: paraphrasing, “we only know what we know now, and we only decide today’s rate decision, which was to raise 25bps. We didn’t deliberate and agree on the median forecasts.” But at the end of the day, the forecasts are interesting in the picture they paint either jointly or by coincidence of the participants’ expectations for the economy and policy: the median forecast sees growth accelerating relative to their last forecast (2.7 and 2.4 in 2018 and 2019 vs 2.5 and 2.1 previously in December), a higher median path for the funds rate (2.1, 2.9, 3.4 for the ends of 2018, 2019, and 2020 up from 2.1, 2.7, and 3.1 previously in December), which, taken together, say that they are more optimistic on the growth outlook, even with a higher rate trajectory.
Perhaps even more interesting in some sense are their inflation projections, which now actually poke just above their target of 2.0%. Specifically, the outlook for headline PCE inflation went from 1.9, 2.0 and 2.0 in 2018, 2019 and 2020 to 1.9, 2.0, and 2.1, and for core PCE inflation, the forecasts rose from 1.9, 2.0 and 2.0 to 1.9, 2.1, and 2.1. Increases in the inflation projection of 0.1%? Why pore over such minutiae? If nothing else, it suggests they are bullish on the economy and their inflation forecasts—i.e., that they will hike 200 bps from the level that existed before today’s hike through the end of 2020, and yet inflation will still end up exceeding their target by a smidge.
Markets Express Concern
The Fed has had a hard time achieving their inflation target since the Great Financial Crisis—in fact, they’ve scarcely hit it on a core basis. That track record of undershooting, along with their current confidence in the likelihood of higher growth, higher inflation, along with a higher Fed funds rate, may help explain the market’s reaction to the meeting. And what do we mean by that? Well, if the higher rate outlook was seen as justified, we may have expected to see a stronger dollar, higher stock prices, and a higher and flatter yield curve as a result. Instead, as the day came to a close, we saw the opposite: lower stock prices, a weaker dollar, and lower interest rates across the curve. So, the market’s net impression— at least for today—is, on the margin, concern that the Fed may be overconfident, and, in particular, too hawkish, and may represent a threat to the economic outlook. Hence the lower stock prices, lower dollar, and lower interest rates.
And this more or less jibes with our view on long-term interest rates: while the Fed may hike the funds rate to 3.4%, that increase is unlikely to be matched by a rise in long-term Treasury yields. Given the global backdrop of an aging demographic, high debt levels, and some major trading partners that have 10-year government bond yields below 1% and sub-target inflation, the equilibrium level for the U.S. 10-year government bonds seems more likely to reside below, rather than above, 3%—in which case this cycle might end like many others with an inverted yield curve—who knows? Maybe even with the Fed funds rate at 3.4% and the 10-year Treasury sub-3%.
At any rate, it is still early days for the recent fiscal stimulus packages, and early days for the Powell Fed, and it may pay to keep an open mind. Long-term rates may yet rise further, particularly if and as growth and inflation accelerate as the fiscal stimulus passes through the system in the U.S. But looking 12-24 months ahead, our base case would see long rates either at or below, and not likely above, current levels, which would allow long-term fixed income to continue to outperform cash, as it has done for much of the current expansion.
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