Fed View: Speakers respond to overheating fears –

A host of FOMC members have been on the wires in recent days, and at what is arguably a crucial inflection point for the US economy: the momentum in the post-pandemic recovery now looks to be peaking, while the biggest monthly gain in core consumer prices since 1981 raised fears that the US is heading for an overheating scenario. As we discuss in our latest Global Monthly, we do not expect such a scenario as a base case.

The recent rise in inflation is due to temporary factors such as: 1) supply-side bottlenecks which are expected to ease in the coming months, 2) catch-up growth from a period of very weak inflation in the pandemic period. We expect the effects of these factors to fade over the coming months and for monthly inflation to fall back to more normal levels (base effects will keep annual inflation higher into next year). However, there is a risk that inflation expectations continue to rise, which in the medium term could trigger a self-reinforcing inflationary dynamic.

Dovishness still reigns, but hints of a communications shift on tapering – The general message from FOMC members has been that the current policy stance remains appropriate, that the economic outlook is strong, and that the recent rise in inflation is driven by temporary factors and is not a concern at this stage.

This is consistent with our view that the Fed will look through the current rise in inflation and will not overreact or respond pre-emptively, as it might have done in the past – and it is further bolstered by the Fed’s new average inflation target framework, which allows the Fed to aim for an overshoot of its 2% target for a time.

For instance, although referring to the April inflation print as an ‘unpleasant surprise’, Vice Chair Clarida said that he thinks inflation pressures are ‘largely transitory’. Even more traditionally hawkish members of the Committee, such as Kansas Fed president Esther George said ‘factors boosting inflation are likely to fade’ and that ‘the economy has not yet fully healed, with 8 million people still out of work’.

With that said, on tapering, there were some hints that a decision is approaching. For instance, Clarida said ‘there will come a time in upcoming meetings, we’ll be at the point where we can begin to discuss scaling back the pace of asset purchases.’ This was echoed by San Francisco Fed president Daly, who said that the Fed is now ‘talking about talking about tapering’ (in a quip referencing Chair Powell’s famous remark that the Fed isn’t even ‘thinking about thinking about rate hikes’).

Taper announcement could come as soon as September – These hints, combined with the Fed’s commitment to telegraph a tapering of asset purchases ‘well ahead’ of time, suggests we could get an announcement as soon as the September or even July meeting. Given the ‘well ahead’ language – admittedly vague – this would imply the actual tapering of purchases starting in Q4. While this is sooner than our current base case of early 2022, we doubt that it would have significant market implications at this stage, given that an aggressive tightening of policy over the coming years is already fully priced in by financial markets.