The COVID-19 pandemic negatively impacted people’s lives in many ways, fortunately, the rapid and aggressive use of fiscal and monetary stimulus provided significant support to the economy and financial markets around the world. This assistance, coupled with multiple approved vaccines, has now brought us closer to the other side of the pandemic with central bankers and politicians facing the process of normalizing policy as the U.S. economy is rapidly reopening and recovering.
Therefore, is now the time for the Fed to start ‘thinking about thinking about’ raising interest rates? We believe the answer is not quite yet. However, the necessary steps leading up to that time are now on the horizon and investors should begin to prepare for that eventuality. Vivid memories of the 2013 ‘taper tantrum,’ or surge in interest rates following the Fed’s indication they were preparing to reduce their bond purchase program are topical once again. In fact, the Federal Open Market Committee (FOMC) minutes from their April 2021 meeting stated, “a number of participants suggested that if the economy continued to make rapid progress toward the Committee’s goals, it might be appropriate at some point in upcoming meetings to begin discussing a plan for adjusting the pace of asset purchases.” Clearly, some inside of the FOMC are ‘thinking about thinking about’ tapering. The question facing investors is whether the FOMC can communicate their plans in such a way as to avoid a repeat of 2013.
To answer these types of questions, it is important to understand how the FOMC’s policy framework has evolved over the past decade, beginning in early 2012 when then Chairman, Ben Bernanke, made explicit the FOMC’s two percent inflation target. Additionally, the FOMC has taken steps to become more transparent in communicating about monetary policy within financial markets, most notably with the addition of press conferences following policy setting meetings and Committee member’s frequent speaking engagements between meetings. The most recent, and some might argue most significant, shift in the FOMC’s policy setting framework came last summer when they announced the move to an “average inflation target.” Essentially, the FOMC will allow inflation to run above two percent following prolonged periods of sub-two percent inflation such that the economy averages two percent inflation over the longer term. Equally as important, in making this shift, the Committee’s monetary policy framework becomes outcome based, not forecast based. In other words, observed trends in hard economic data will drive policy adjustments, not simply changes in the Committee’s forecasts.
So where does all this leave us currently? The U.S. economy is growing at a rapid pace, driven by state’s reopening, pent up demand following a year of restricted mobility and consumers flush with stimulus money to support increasing economic activity. Similarly, inflation metrics are at elevated levels not witnessed in many years. While base effects play a role in the current inflation readings, supply chain disruptions, elevated commodity prices and strong demand are also exerting upward pressure. On the surface, one could conclude the FOMC should begin reducing monetary policy accommodation imminently. Investors experienced a glimpse of this in the first quarter as intermediate and long-term interest rates increased significantly following positive vaccine news and stronger economic data. The ten-year U.S. Treasury note yield increased 83 basis points to 1.74% during the quarter.
The second element of the FOMC’s dual mandate, maximum employment, shows the other side of the debate. While significant progress in getting people back to work has been made, there remains significant slack in the labor markets with the current unemployment rate at 5.8%, relative to the 3.5% rate of unemployment the U.S. had just prior to the pandemic. Following the strong jobs report in March, many thought the labor market recovery could be a rapid recovery as well. However, judging from the employment reports from the last two months and with additional unemployment insurance benefits still in place, progress on the employment front may be slower than many had initially hoped. To date in the second quarter, the ten-year U.S. Treasury note yield has declined 29 basis points to 1.45%.
The FOMC has made it very clear that monetary policy will remain accommodative until their policy outcomes have been achieved. Given the expectation for robust GDP growth, elevated inflation readings and a gradually declining unemployment rate, we do expect the Fed to begin telegraphing the tapering of their bond purchase program later this summer, with the process beginning late this year or in early 2022. The FOMC will likely follow with increases in the federal funds rate sometime in late 2022 or early 2023, barring any sort of economic setback. Interest rates should gradually drift higher over the coming quarters as investors position for these policy changes.
The next several quarters will test the Fed’s efforts to balance appropriate policy and transparency with the markets expectations for higher interest rates. At a minimum, we believe increasing interest rate volatility seems inevitable given the cross currents between economic data, investor expectations and the FOMC’s messaging. We would encourage investors to remain patient as the economy recovers and, perhaps most importantly, be mindful of the changes in the FOMC’s policy framework as they evaluate the future path of monetary policy and interest rates.
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.
Greg Oviatt, CFA
Executive Vice President, Senior Portfolio Manager
Boyd Watterson Asset Management, LLC