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The Federal Reserve stresses it won’t raise interest rates until the U.S. economy shows tangible evidence it has fully recovered from COVID-19 and that there are persistent inflationary pressures. Kim Parlee speaks with Priya Misra, Global Head of Rates Strategy at TD Securities.
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- The closely-watched Fed meeting happened today, with the announcement from Jerome Powell. And no one's surprised. Rates remained steady but also had a much brighter outlook for growth than some had been expecting. Priya Misra joins me-- she's global head of Rates Strategy at TD Securities-- to unpack this and every subtlety that came out with it. Priya, it's great to have you with us. I'm just going to start with the big question. From what you heard today, what really stood out?
- I think a very dovish reaction function from the Fed. That was apparent from the fact that they upgraded their growth forecasts, the unemployment forecast, the inflation forecast, and yet the median 2023 dot didn't move. Now, we were not expecting it to move, but you can tell with price action in the Treasury market in the last month, the market's been wondering at what point does the reflation trade become too much, too much of a good thing? And does the Fed need to start to remove accommodation? I think tapering was a big fear into this meeting, the start of tapering. Is it signaled right now? Do hikes move sooner?
So I think what we heard from Jay Powell was that even if growth picks up, they want to see inflation overshoot. He reaffirmed the commitment to the inflation overshoot, and that to us tells us that this is positive for the reflation trade continuing for a while. It could still mean higher rates in the long end because we have a lot of supply to take down, but at least the front end gets more anchored. And that was what was looking a little shaky into the meeting, and I think the Fed managed to regain control of the front end of the yield curve for now.
- Which I think is, to your point, what everybody was watching. There's some specific wording here. I want to fly this by you. They talked about the fact they're not going to preemptively move based on forecast but rather will rely on action data. What does that mean in plain speak?
- That is very different. I'm glad you brought that up. That's actually very different from previous Fed speak as well as other central banks. Central banks tend to work off forecasts, and if the forecasts are that much positive, why isn't the Fed talking about hiking in 2023? I think they're telling you that there are huge uncertainty bands around the forecast. And, to be fair, we're in very unprecedented times. We've never seen this level of fiscal support. We've never seen a pandemic, at least in our lifetimes.
And so big questions about how quickly does the service sector rebound, do we get the inflation pressures, or do the structural disinflationary pressures take over? I think these are big questions the Fed doesn't want to almost opine on or act on, which is why they're telling us that they'll actually want to see inflation overshoot. Importantly, also, that it's not transitory, which tells me that if it overshoots, they're going to watch for another-- and this is where they haven't been specific. Is it six months? Is it one year? They'll want to see that inflation number staying high before they actually believe their forecasts. So it's interesting, the central banks telling you that they may not believe their forecast or they're certainly not willing to act on their forecast. I think they're telling us they actually want to see it before they remove accommodation.
- Yeah. It's fascinating. The transitory piece is so interesting because, you know, coming into the pandemic, I mean, it was a very disinflationary environment. So I guess the question is do we still see that overlaid on everything? Like this is something we're going to have to get through, but, you know, fast-forward out much further along, do we go back to the same issues around inflation?
- Right. That is very much our forecast. But I am hearing from investors who are questioning that. So we've had this view that the level of debt in the system, the demographics, the fact that the advanced economies are an aging population, globalization, technology, all of these are disinflationary forces. And then we had COVID on top of it, which also, I would argue, is a disinflationary shock. I would think these structural factors remain, and I think the Fed is in that gap, which is why they expect any pickup in inflation due to base effects or reopening of the economies to be transitory. In fact, their forecasts show that inflation rises this year and then comes back down next year.
I think the market is questioning that a little bit. There are investors and economists who believe that with all the fiscal stimulus we've seen, it might be enough to offset some of the structural factors. I think the Fed's telling you they don't believe it, but they will let the data speak for itself. But we're very much in the camp that there are structural forces. And I would say the use of technology has actually accelerated post-COVID. So in fact, some of these trends might have become stronger disinflationary forces. Once you get the pandemic-related inflation, reopening-related inflation, out of the way, we go back to the structural disinflation. But I guess this is the big question mark for next year and beyond.
- What are you going to be watching to see those hints of inflation? Or maybe I should ask the question what do you think the Fed is going to be watching closely to really see that the inflation has taken hold and they're comfortable with it?
- Right. So I think this is interesting because when we look at the data, number one, we should see is it month over month or just a year over year number? If it's just a year over year number that's going up, then what the Fed calls base effects, or what economists call base effects, are at play, because a weak reading a year ago is coming off the data series. It's making the year over year number look good. I think that the market will ignore and the Fed will ignore. If the month over month numbers are picking up, then the next question is how broad-based is that? We do get sector-wise breakdown. Is it driven by used cars? And we saw this last year because everyone stopped, or a large number of people stopped, you know, using mass transit. Well, if it's that, that's a one-off. If it's a broad-based increase in inflation, I think that then the question is, is it because of some supply chain slash reopening-related increase?
And I think we don't know that. But if it lasts for a while, and we're thinking at least six, seven months, then we'll think that this is more than just a reopening-related increase in inflation. So there's multiple levels as we are looking and analyzing inflation data that I think the Fed will be watching. What we heard from them is they're in no rush to remove accommodation. So I think they'll err on the side of broad-based increase in inflation for at least six months for them to start to think that perhaps this is the real thing, that they can actually believe that the structural disinflation may be a thing of the past. They're not quick to jump to that conclusion right now.
- Priya, I've only got about 30 seconds, but when the Fed does finally make a move or starts to kind of creep in that direction, what comes first? I mean, is it rates? Is it bond buying? We talked about SLR's today. Lots of people asking about that. What do you see happening as the thin edge of the wedge, so to speak?
- I think it's going to be the signal for tapering. What we heard today was they're going to tell us well in advance. I will say the market will react to that signal. Even in the taper tantrum, we reacted to the talk of taper rather than the actual tapering. So it's when they give the signal, then they'll start the tapering. It's going to be a gradual taper, and then they hike. So it's many steps to hike, but watch for that signal that they think substantial further progress has been made. That that's the start of a long process of removal of accommodation.
- Priya, always a pleasure. Thanks so much.
- Thank you.
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- I think a very dovish reaction function from the Fed. That was apparent from the fact that they upgraded their growth forecasts, the unemployment forecast, the inflation forecast, and yet the median 2023 dot didn't move. Now, we were not expecting it to move, but you can tell with price action in the Treasury market in the last month, the market's been wondering at what point does the reflation trade become too much, too much of a good thing? And does the Fed need to start to remove accommodation? I think tapering was a big fear into this meeting, the start of tapering. Is it signaled right now? Do hikes move sooner?
So I think what we heard from Jay Powell was that even if growth picks up, they want to see inflation overshoot. He reaffirmed the commitment to the inflation overshoot, and that to us tells us that this is positive for the reflation trade continuing for a while. It could still mean higher rates in the long end because we have a lot of supply to take down, but at least the front end gets more anchored. And that was what was looking a little shaky into the meeting, and I think the Fed managed to regain control of the front end of the yield curve for now.
- Which I think is, to your point, what everybody was watching. There's some specific wording here. I want to fly this by you. They talked about the fact they're not going to preemptively move based on forecast but rather will rely on action data. What does that mean in plain speak?
- That is very different. I'm glad you brought that up. That's actually very different from previous Fed speak as well as other central banks. Central banks tend to work off forecasts, and if the forecasts are that much positive, why isn't the Fed talking about hiking in 2023? I think they're telling you that there are huge uncertainty bands around the forecast. And, to be fair, we're in very unprecedented times. We've never seen this level of fiscal support. We've never seen a pandemic, at least in our lifetimes.
And so big questions about how quickly does the service sector rebound, do we get the inflation pressures, or do the structural disinflationary pressures take over? I think these are big questions the Fed doesn't want to almost opine on or act on, which is why they're telling us that they'll actually want to see inflation overshoot. Importantly, also, that it's not transitory, which tells me that if it overshoots, they're going to watch for another-- and this is where they haven't been specific. Is it six months? Is it one year? They'll want to see that inflation number staying high before they actually believe their forecasts. So it's interesting, the central banks telling you that they may not believe their forecast or they're certainly not willing to act on their forecast. I think they're telling us they actually want to see it before they remove accommodation.
- Yeah. It's fascinating. The transitory piece is so interesting because, you know, coming into the pandemic, I mean, it was a very disinflationary environment. So I guess the question is do we still see that overlaid on everything? Like this is something we're going to have to get through, but, you know, fast-forward out much further along, do we go back to the same issues around inflation?
- Right. That is very much our forecast. But I am hearing from investors who are questioning that. So we've had this view that the level of debt in the system, the demographics, the fact that the advanced economies are an aging population, globalization, technology, all of these are disinflationary forces. And then we had COVID on top of it, which also, I would argue, is a disinflationary shock. I would think these structural factors remain, and I think the Fed is in that gap, which is why they expect any pickup in inflation due to base effects or reopening of the economies to be transitory. In fact, their forecasts show that inflation rises this year and then comes back down next year.
I think the market is questioning that a little bit. There are investors and economists who believe that with all the fiscal stimulus we've seen, it might be enough to offset some of the structural factors. I think the Fed's telling you they don't believe it, but they will let the data speak for itself. But we're very much in the camp that there are structural forces. And I would say the use of technology has actually accelerated post-COVID. So in fact, some of these trends might have become stronger disinflationary forces. Once you get the pandemic-related inflation, reopening-related inflation, out of the way, we go back to the structural disinflation. But I guess this is the big question mark for next year and beyond.
- What are you going to be watching to see those hints of inflation? Or maybe I should ask the question what do you think the Fed is going to be watching closely to really see that the inflation has taken hold and they're comfortable with it?
- Right. So I think this is interesting because when we look at the data, number one, we should see is it month over month or just a year over year number? If it's just a year over year number that's going up, then what the Fed calls base effects, or what economists call base effects, are at play, because a weak reading a year ago is coming off the data series. It's making the year over year number look good. I think that the market will ignore and the Fed will ignore. If the month over month numbers are picking up, then the next question is how broad-based is that? We do get sector-wise breakdown. Is it driven by used cars? And we saw this last year because everyone stopped, or a large number of people stopped, you know, using mass transit. Well, if it's that, that's a one-off. If it's a broad-based increase in inflation, I think that then the question is, is it because of some supply chain slash reopening-related increase?
And I think we don't know that. But if it lasts for a while, and we're thinking at least six, seven months, then we'll think that this is more than just a reopening-related increase in inflation. So there's multiple levels as we are looking and analyzing inflation data that I think the Fed will be watching. What we heard from them is they're in no rush to remove accommodation. So I think they'll err on the side of broad-based increase in inflation for at least six months for them to start to think that perhaps this is the real thing, that they can actually believe that the structural disinflation may be a thing of the past. They're not quick to jump to that conclusion right now.
- Priya, I've only got about 30 seconds, but when the Fed does finally make a move or starts to kind of creep in that direction, what comes first? I mean, is it rates? Is it bond buying? We talked about SLR's today. Lots of people asking about that. What do you see happening as the thin edge of the wedge, so to speak?
- I think it's going to be the signal for tapering. What we heard today was they're going to tell us well in advance. I will say the market will react to that signal. Even in the taper tantrum, we reacted to the talk of taper rather than the actual tapering. So it's when they give the signal, then they'll start the tapering. It's going to be a gradual taper, and then they hike. So it's many steps to hike, but watch for that signal that they think substantial further progress has been made. That that's the start of a long process of removal of accommodation.
- Priya, always a pleasure. Thanks so much.
- Thank you.
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