Even before it was revealed that US inflation had surged to 5.4% in June, concerns had been rising that the US Federal Reserve was complacent about the risks. Fed chair Jay Powell probably did little to mollify inflation hawks in a recent congressional hearing. But can the Fed really be accused of inaction?
To answer this question, it is worth revisiting June’s meeting of the US Federal Open Market Committee. This meeting was even more heavily anticipated than usual, with markets waiting with bated breath for revisions to forecasts for growth, inflation, unemployment and future policy rates. The US economy has, of course, leapt off the starting blocks this year and the recent revisions by the Fed acknowledged this unexpected strength. Growth in 2021 was revised higher to 7.0%; the US unemployment rate expected at the end of next year was cut marginally to 3.8%; and the forecast inflation profile out to end-2023 was nudged higher to 2.2%.
The changes came as no surprise, given the scale of planned government intervention in the US economy and the effectiveness of the vaccination rollout. However, the projection for long-run US inflation remained unchanged, with the 2% target remaining in place, despite the potential short-term surge to 5.4% witnessed in June. The Fed’s estimate of trend GDP growth was also unchanged, at 1.8% per year.
We can only speculate what advanced economies would be like without the years of ultra-accommodative monetary and now fiscal policy they have had. Could the recent surge in inflation put pressure on the Fed to change its ways and slow monetary stimulus sooner?
Central banks are at the top of their game when they can adjust market pricing without actually doing anything. In many cases, actions are always greater than words and often, by offering a nudge and a wink, the Fed can take the steam out of developing excesses or, conversely, embolden risk appetite — as was the case at the June FOMC, when by simply hinting at policy rate increases in 2023, it capped market-priced inflation rates and took the top off an array of reflation trades. This simple nudge by the Fed caused the US yield curve to flatten by 0.25%; globally, value stocks lost 3% relative to growth stocks, and, perhaps most notably, the US dollar rose by nearly 2%.
However, it is important to take a step back and retain some perspective from these reversals — a lot can and will happen between now and the end of 2023. Even if the Fed’s forecasts prove correct, US policy rates will still only be 0.6% by the end of that year. If that is a problem for the US economy, we are really in trouble.
Within its framework, however, the end of 2023 is as distant as it can go without altering its equilibrium forecasts; note that the most popular estimate by FOMC members for the US policy rate is ‘unchanged’.
The point is, of course, that the Fed is signalling the beginning of the end of extraordinary policy accommodation. This is not the first such signal since the Great Financial Crisis and yet policy remains extraordinarily accommodative. Even if correct, money markets still suggest that US policy rates will be lower than the Fed’s equilibrium estimate at the end of 2029.
None of this will be lost on the Fed. After watching US inflation surge through 4% in April and hit 5% in May, some official response was needed to keep markets orderly and avoid accusations of imprudence. Their action was well-timed. As US inflation rose afresh in June, it is noteworthy that markets, with their trust in the Fed reaffirmed, have remained calm.
Looking to the summer, investors have to contend with still-lofty equity valuations. The latest US flows-of-funds data points to investors being ‘all in’ in spring. However, the global economy will be unable to sustain the growth surge. Coupled with talk of sticky inflation and now a Fed ‘on the turn’, there are events on the horizon that may cause investors concern.
Were it not for the continuing strength in corporate profits, this would likely be more than the market could withstand. However, profits are rising firmly, the outlook for capital investment has rarely looked better and governments continue to write cheques as never before. The Fed is encouraging markets to let off steam. This is something that investors should welcome.
Stephen Jones is CEO of Aegon Asset Management UK