Fixed Income Boutique
The U.S. Federal Reserve’s annual summer symposium in Wyoming represents an important data point for financial markets since it provides valuable clues as to the policy moves the Fed may make in the ensuing twelve months. This year will be no exception and the investor community should listen carefully. It usually chooses not to resulting not only in quite some market volatility but also opportunities.
Take last year’s gathering for instance, when the Fed introduced their new inflation framework “Average Inflation over Time” (AIT). The Committee and Chair Powell have remained firmly committed to it since then. In fact, over the past twelve months, Powell has been re-iterating that they will not raise rates pre-emptively on the fear that the labor market could be over-heating or that inflation could possibly accelerate. One key component of their new AIT framework is their insistence on actual data rather than just forecast data, especially given their inflation expectation forecast was repeatedly missed or undershot from 2012 to 2020. Over the 10 years up to the pandemic we saw disinflation digging in its heels, which explains the Fed's caution on making moves on rates based on inflation data.
The second key component of AIT lies in its four words: Average Inflation over Time. What really matters for the Fed is for inflation to take hold and be sustained. Therefore, the Fed is likely to look at inflation prints over an extended period, at least 3 years, rather than just a few inflation data releases. Looking at 3-year rolling core personal consumption expenditures (PCE) for instance would be more appropriate. This measure is likely to stay below the Fed’s 2%-target in 2022 - hence the Fed’s patience. It is needless to say that the hurdle rate for rate hikes due to inflation is extremely high under the new Fed framework and that this year’s US treasury rates move was unwarranted.
Since the Fed was quite vocal about being patient this year in light of their new AIT framework and about not acting pre-emptively based on forecasts but wanting actual data, they might choose to reinforce the framework by addressing a persistently uneven employment picture alongside a low average inflation environment. The theme of this year’s symposium “Economic Policy in an Uneven Economy” seems to support this view as it supposes a focus on the employment picture and rising inequality driven by technological and digitalization advances. This implies that the Fed would be unlikely to consider reducing asset purchases unless the labor market manages to achieve broad-based and inclusive gains.
Governor Brainard was quite clear on the subject, actually. In assessing substantial further progress on tapering, she said she would like to see “indicators that show the progress on employment to be broad-based and inclusive, rather than solely focusing on the aggregate headline employment rate”. Her most recent remarks on July 30 in Aspen, Colorado, indicated that unemployment remained high and that employment continued to fall disproportionately among African Americans and Hispanics and lower-wage workers in services. According to her office, there was still a significant shortfall in prime-age low-skilled workers and in black individuals in June amounting to a shortfall of 9.1 million jobs compared to the pre-pandemic trend - a special indicator closely watched by the Fed.
Given this backdrop, tapering asset purchases might well be talked about at this year’s symposium but not actioned upon until well sometime in 2022, especially given Powell’s discussions on low employment and inflation in March 2021: “We had low unemployment in 2018, 2019 and the beginning of 2020 without troubling inflation at all”. This could motivate him to slightly delay tapering to ensure that the recovery in employment is more even on a more definite basis.
Another reason to delay tapering are the downside risks associated with the Delta variant of the COVID-19 virus. In many areas, vaccination rates are not as high as one would have hoped and may dampen the rebound in the services sectors that account for three fourth of the shortfall in jobs according to Ms. Brainard. This would suggest that we still have some distance to go in achieving substantial further progress in employment before the Fed begins to slow asset purchases.
It is worth remembering that after the Great Financial Crisis of 2009, broad based labor market conditions only showed very slow improvements despite the Fed being accommodative and quite patient. This could repeat itself this time around especially given the greater advances and rapid implementation of digital structures in the global economy. With regards to Europe, the European Central Bank (ECB) is likely to follow in the Fed’s footsteps given that the polarization of the job market is also a key concern of ECB President Lagarde.
Markets could end up surprised about the Fed continuing its asset purchases until actual broad-based gains in employment have been fully achieved. This is because markets tend to focus on aggregate headline measures which makes them think the Fed will start tapering in the relatively near term. Delaying tapering would reinforce the Fed’s dovishness which would be supportive of both government and corporate bonds, especially investment-grade subordinated structures and higher yielding bonds. Overall, shifting the “lower-for-longer” regime seems difficult in an uneven and digital economy.