The U.S. Federal Reserve is planning to withdraw its stimulus measures more quickly than planned as it takes steps to deal with record inflation. Kim Parlee speaks with Priya Misra, Head of Global Rates Strategy, TD Securities, about the Fed’s efforts and what to expect in 2022.
Priya, always great to have you with us. Maybe you could just take us through the big question, which is what happened? And why did the equity markets rally on what came out today?
- Sure. So we got a very hawkish message from the Fed today. And that's why, guys, I see your question-- why is the premarket up? I think it's worth putting in context where interest rates are. So what we heard from the Fed today is they accelerated the pace of taper. They'll be done by March. And they talked about, at least, median hikes of three hikes next year.
But I think it's worth looking at the long end and where are 10-year treasury rates. And real rates are minus 1%. And so financial conditions are extremely accommodative. I think the Fed is saying, yes, we need to respond to inflation, and we need to start to hike. And they've taken a step-- a pretty important step in that direction today.
But I think the market is looking at overall conditions, and even if the Fed was to end tapering and hike three times, that's not necessarily that restrictive of a policy stance. And I think that's probably what the market looked at for comfort, but the Fed is not panicking. They're not talking about raising much beyond neutral. I think there have been some economists who've been saying, maybe the Fed needs to get to 3% or 4%. And the Fed's long-run policy rate is still 2.5%.
So even though it's hawkish-- it was a hawkish shift today-- it's a message of gradual hikes to neutral. And I think that's what the market probably cheered at, but we did see the interest rate reaction with higher rates, as the market's now pricing in imminent rate hikes.
- It's interesting because the way you're describing it-- I also heard someone else talk about you. This is a front-end-loaded action from the Fed, which I think speaks to what you're saying is lots could happen quickly, but then it's going to pause. Or to get to that rate you were talking about, it's a little more longer-- or more neutral in the longer end.
- Exactly. Yes. I think there wasn't a sense that the Fed is under urgency to raise rates beyond neutral or to let the balance sheet run off earlier. There have been some who have argued that in order to get inflation under control, the Fed should let the balance sheet run off sooner than what I think the market was pricing in. And we heard a sense of gradualism, even in terms of the balance sheet.
They started the discussion, but then they are not in any hurry to start to let the balance sheet run off. That's why I think the long end has been more stable and low-- those real rates are still going to stress on how low the real rates in the Treasury market. And that's helping risk assets. It's helping the economy, frankly, because ultimately, the economy does respond to real rates. So yes, it was much more about hikes-- not that much moving that long-end much higher.
- What is your take on the longer term, I'd say, inflation and economic picture, especially when you introduce something like Omicron variant into the mix? I mean, what are you going to be watching?
- Right. I think there's the Fed reaction function, which we got a sense of today, and then there's the economic outlook. And that's where Omicron comes in, and the uncertainty is very high. I mean, the economy right now is very strong. And that's what we heard from the Fed as well. GDP is running close to 6% in the fourth quarter. Inflation's really high. But where we talk about caution here is extrapolating from that.
A lot of the improvement in growth this year was-- some of it was vaccinations and reopening, but a lot of it was fiscal stimulus. And that runs out. And so we're looking for growth momentum to decelerate next year. Now, Omicron can add downside risk to that. But on the flip side, inflation, which we expect to start to also decelerate to some of the supply chain disruptions, should ease.
Well, if Omicron becomes much worse, and we have widespread shutdowns in certain parts of the world, that could actually worsen supply chain. So you could actually have upside risk to inflation because of Omicron. So what we'll be watching over the next six months, I think, it's going to be inflation and growth. But it's going to be also to try and see trend versus is it Omicron-impacted, in which case, I'd say, it should not last.
Hopefully at some point, this surge in Omicron will also come down, and then we'd be looking for that trend level of growth and inflation, and does that support the Fed starting to hike by the middle of next year?
- Fingers crossed. I hope that happens. Priya, I've only got about 10 seconds, but with all these crosscurrents, I'm sure it's hard to give a forecast, but what are you looking for for the US dollar?
- So we've got a strong dollar forecast in the near-term, because, really, the US growth story-- the USA is the strongest growth part of the world. I mean, we have the ECB meeting tomorrow, so that could be very interesting. We don't think the ECB is at the point of the Fed in making this hawkish pivot. So I think the dollar should strengthen against the euro.
But then there are other parts of the world-- EM, for example-- where the dollar might have a tougher time. So I think rather than thinking of the dollar as a whole, I think there's pockets of strength in the dollar. And then other areas, where we think that EM, Asia, should probably outperform the US dollar. So some differentiation there.
- Priya, always a pleasure. Thanks so much.