Fed Announcement — December 15, 2021

Another Powell Pivot

Today marks another change in policy by the Federal Reserve’s Open Market Committee. The bond buying program, called Quantitative Easing, will be wound down by March instead of mid-summer. Phasing out the bond buying program gives the Fed flexibility to raise rates earlier next year, earlier than prior expectations. The decision to accelerate the wind-down of the pandemic bond buying program was driven by recent inflation reports. Consumer and producer price indices have consistently moved higher since March of this year.

Following the playbook announced last year, the Fed did not change short-term interest rates. The plan is to finish the bond buying program before raising rates. Fed Funds futures are pricing quarter point increases in May, September and December. This suggests an overnight rate at the end of December of 0.75%. That level should push 2-year Treasury notes to roughly 2% and 10-year notes closer to 3%, levels last seen in 2019. Note that bond yields are not yet moving in that direction. 

Inflation

Commodity and wholesale goods prices started moving higher last fall. Like many prior recoveries, early inflation in this recovery cycle was driven by supply chain and reopening demand. Since March of this year, inflation has broadened to almost every sector of the economy. 

November producer prices are running at a 9.6% rate over last November. Consumer prices have accelerated since March, averaging 5.45% per month, rising at a 6.8% rate over November 2020. As Chairman Powell stated in the press conference, “this is not the inflation we were looking for.” 

March marked the pivot month for consumer prices, thanks to Congress distributing $1.9 trillion directly to consumers and governments. In the decade leading up to March 2021, consumer inflation averaged 1.6%. 

What about rates?

The Fed’s tests for raising short-term rates are: 1) inflation “averaging 2% for some period of time,” and 2) “full employment.” The Fed would like to believe the supply chain issues created “transitory” inflation. Absent fiscal spending by Congress, that may have been the case. Prices rising almost 10% across the board — housing nearly 30% in some places and energy 50% higher — has the Fed’s attention. So put a check mark by #1. 

Full employment remains an enigma to Fed watchers. In his press conference today, Chairman Powell acknowledged that rising wages and record-high quit rates are good signals for full employment. Wages are rising but not keeping pace with inflation. Quit rates are at all-time highs because plenty of other jobs are available. Retiring Baby Boomers are also lowering the available pool of workers, making comparisons of labor force participation to pre-pandemic levels difficult. 

Comment

We believe the Fed’s tests have been met. The case for returning to pre-pandemic interest rates is supported by rising earnings, strong consumer and business balance sheets and the global recovery. New virus strains remain an issue along with geopolitical events. Both create “flight-to-safety” events that lower interest rates.  

Markets like certainty and are taking the Fed’s decision well. Most traders wanted to hear that the Fed is ready to act on inflation and that is what they got. A majority of Committee members believe rates will be increased three times next year. Their GDP forecast for 2022 was revised lower from 5.9% in September to 5.5%. The Fed does expect inflation to decline sharply in 2022 to 2.6%. We think inflation averages a full percentage point higher at 3.5% for the full year. 

Stock markets remain in a holding pattern, consolidating within a few percent of their recent highs. Commodities and bond prices are also holding steady. The spread between 2- and 10-year notes — an important indicator for funding loans — has moved several basis points higher to 0.79%. Monetary conditions are, and will remain, very accommodative. The Fed will maintain the size of the bond portfolio at nearly $9 trillion, or about 40% of the U.S. economy. 

We would have liked the Fed to have acted earlier in this recovery cycle. The key for markets and investors in the coming months is how quickly the economy decelerates from very fast rebound growth. Regardless, GDP growth next year above 5% will be nearly triple the previous decade.