The Federal Reserve’ June meeting marked a shift from the previous post-pandemic meetings as it struck a remarkably hawkish tone, even with minimal changes in its written statement. As expected, there was an adjustment of administrative rates, with a five-basis-point technical increase to interest on excess reserves and the reverse repo rate.
The Fed’s summary of economic projections saw upward revisions that were even better than expected from an optimistic investor base: GDP projections were up markedly, upgrading 2021 by +0.5 percentage points (pp), no change to 2022 and adding 0.2pp to 2023 projections. However, a strong upward adjustment in inflation was limited to this year at +1.0pp in headline and +0.8pp in core, but only +0.1pp in 2022 and 2023 for both core and headline, reflecting a Fed that suddenly expects to meet its “substantial further progress” goal much sooner than expected but still believes its longstanding view of a transitory inflation outlook.
The big surprise, however, came from the dots that normally reflect the FOMC’s expected path of the monetary policy rate; The dot median rose to two hikes in 2023, up from zero as of March, reflecting the increase in Fed members calling for at least one hike, now at 13 versus seven in March.
In the ensuing press conference, Fed Chair Jerome Powell did little to tone down the hawkish rhetoric, while acknowledging:
- The start of an ongoing conversation around tapering
- The likelihood of a shift in the labor force due to an increase in retirement that could reduce the number of jobs that fulfills the Fed’s “maximum employment” threshold
- The upside risk to inflation, and the Fed’s humility that the committee could be underestimating inflation after all
This leads us to conclude, first, that committee members are getting worried about falling too far behind the curve; as such, we anticipate that every Fed meeting from here could include a tapering announcement. Second, we believe interest rate volatility is about to pick up again, as the market attempts to reprice interest rate expectations. Third, when the Fed finally starts to raise rates, depending on the level and path of inflation, the pace of liftoff could be steeper than currently anticipated.
To us, the key investment implication is most likely higher rates, with a trajectory of inflation expectations that will be highly dependent on the pace of an eventual tapering. An aggressive tapering scenario would probably cause a repricing in the liquidity premium for breakeven inflation, as the key Treasury Inflation Protected Security (TIPS) buyer exits the marketplace.