The Federal Reserve has begun tiptoeing away from the extraordinary measures it adopted to help the US cope with the coronavirus pandemic. For the moment this does not consist of any big leaps — in its meeting this week it did not change its policy rate nor “taper” the pace at which it purchases assets through its quantitative easing schemes — but of changing how the central bank communicates its intentions. The Fed is right to tread carefully: there is still a lot of uncertainty about the outlook.
Chair Jay Powell noted in the press conference on Wednesday, following the meeting, that the prognosis for the US economy was better than the Fed had previously forecast. Vaccinations, policy support and the reopening of businesses all meant that growth, employment and inflation were higher than the central bank had expected. “There’s every reason to think that we’ll be in a labour market with very attractive numbers,” Powell said.
The rise in inflation, however, is a concern for the central bank. The speed at which prices have risen has surprised the policy committee — the central bank was forced to revise up its forecast for core inflation, which strips out volatile food and energy prices, to 3 per cent this year from 2.2 per cent at its March meeting. “Bottlenecks” from the reopening of the US economy had been larger than expected, the Fed said, although it still expects these effects to be “transitory”, with core inflation falling to 2.1 per cent in 2021.
Nevertheless, this faster than expected inflation has contributed to a more hawkish tilt to communications, albeit in the context of a very dovish set of policies — the central bank kept its interest rate target at 0 to 0.25 per cent and rate of asset purchases at $120bn a month. Investors should think about this meeting as “the talking about talking about tapering meeting, I guess”, in the words of Powell. Such indications that the central bank was beginning to think about reducing its asset purchases was enough, along with an update to the central bank’s forecasts of interest rates to lift yields on US treasuries as well as the dollar.
The Fed has deftly handled this shift. Investors and the central bank have largely converged on the same point — market-based estimates of inflation have plateaued after rising at the start of the year while expectations of an interest rate rise in 2022 have faded. The central bank has demonstrated that it can, under its new framework, respond to better than expected data and signal rising interest rates without destabilising markets.
This will be vital. There is considerable uncertainty about the outlook. As Powell noted, while the labour market is recovering, the long-term effect of the pandemic has not become entirely clear. The unemployment rate may have halved in the past year but many American workers have dropped out of the labour market entirely. With time, and supportive monetary policy, they may come back. Or, of greater concern, it may be that the “full employment” the Fed is aiming for may already be far closer than it thinks and keeping policy loose will only contribute to inflationary pressure.
Other cost pressures, too, may be far less transitory than the Fed currently expects. Lumber prices may have fallen from the spike they reached earlier this year off the back of a construction and DIY boom but they are still up compared with the post-financial crisis norm. Meanwhile, commodity traders, for their part, are forecasting that oil could reach $100 a barrel. Powell has already demonstrated his ability for fancy footwork. That is encouraging: he is likely to need it again.