How soon could the Fed begin tightening monetary policy?

June 21, 2021

4 minute read

by Megan Roach, Russell Investments

On the latest edition of Market Week in Review, Director and Senior Portfolio Manager Megan Roach and Senior Client Investment Analyst Chris Kyle discussed key takeaways from the recent U.S. Federal Reserve (the Fed)’s policy meeting as well as the latest reports on inflation from around the world. They also reviewed the latest U.S. retail sales and jobless-claims numbers, and wrapped up the segment with a look at recent market performance.

Fed signals easy-money policies may change earlier than anticipated

At the conclusion of its June 15-16 policy meeting, the Fed sounded a more hawkish tone, signaling that changes to its ultra-accommodative monetary policy may be coming sooner than markets have been expecting, Roach said. In particular, the central’s bank’s so-called dot plot—where individual members of the Federal Open Market Committee (FOMC) indicate their projections for future interest rates—was reflective of a decidedly more hawkish outlook, she noted, with 13 FOMC members predicting an increase in the federal funds rate by the end of 2023.

“During the ensuing press conference, Fed Chair Jerome Powell said multiple times that favorable economic conditions—longer-term inflation of 2% and full employment—may be met somewhat sooner than anticipated,” Roach said, explaining that the steep drop in U.S. COVID-19 cases and the continued lifting of business restrictions are helping to accelerate the nation’s recovery. Amid this backdrop, she expects that the central bank will begin lifting rates sometime around the fourth quarter of 2023.

Powell also addressed the topic of scaling back on the central bank’s asset-purchasing program, stressing that the Fed will give plenty of advance notice before it begins tapering its monthly bond purchases of $120 billion, Roach noted. She expects that the central bank will discuss tapering at its annual August economic policy symposium in Jackson Hole, Wyoming, or during its September policy meeting. If this is the case, the actual process of reducing monthly bond purchases probably wouldn’t occur until the beginning of 2022, Roach remarked.

Inflation accelerates in Europe

Inflationary pressures are playing a key role in the Fed’s more hawkish outlook, Roach said, with further evidence of accelerating inflation released the week of June 14. “The latest reports from the UK, France, Germany and the eurozone show that inflation continued to rise during May, increasing at a rate of 2% to 2.5% (on a year-over-year basis) in some cases,” she explained.

Roach said that the elevated inflation levels haven’t been too surprising, given that they’re in comparison to extremely weak inflation numbers from last spring, when large swaths of the global economy were shuttered to slow the spread of the coronavirus. However, additional transitory factors, such as supply-chain bottlenecks and a surge in consumer spending, have probably added a bit more fuel to the nation’s red-hot economy than even the Fed anticipated, she stated.

“This has led the Fed to revise its median estimate for 2021 headline inflation up a full percentage point, to 3.4%, with the central bank’s forecast for core inflation adjusted upward to 3%,” Roach noted, emphasizing that she believes inflation will moderate back toward the Fed’s longer-term goal of 2% once these factors subside.

What caused the drop in U.S. retail sales?

Turning to other recently released economic data, Roach noted that U.S. retail sales for May actually came in weaker than expected, decreasing 1.3% from April. While sales were expected to drop off a bit following the massive stimulus-fueled increases in March and April, consensus expectations had been for only a 0.6% drop, she said.

So, what drove the larger-than-anticipated decline? A decent amount can be attributed to May’s drop in automobile sales, due to the ongoing global semiconductor chip shortage, Roach said. In addition, there’s been a notable pivot in consumer-spending habits, from goods to services, as more Americans begin traveling and dining out again, Roach explained. She added that, overall, consumer spending remains robust—just not at the peak levels seen earlier in the spring.

Shifting to labor-market news, Roach said that weekly U.S. initial jobless claims for the week ending June 12 were a bit disappointing, with the total number of claims rising for the first time in seven weeks. However, she stressed that job creation is still expected to run strong over the coming months, albeit with uneven improvement at times.

Equity markets drop as Fed sounds hawkish tone

Focusing in on the market reaction to the Fed’s policy meeting, Roach said that while long-term U.S. government-bond yields ended the week relatively flat, yields on short-term bonds rose considerably, leading to a flattering of the U.S. Treasury yield curve. Equity markets, meanwhile, fell from their recent all-time highs in response to the Fed’s hint of a shift in monetary policy, she stated, with the benchmark S&P 500® Index dropping over 1.5% the week of June 14, as of midday Pacific time on June 18.

“During this pullback, we’ve seen more resilience from some of the larger growth and tech names, while more rate-sensitive sectors like financials, energy and materials have fallen a bit more from their reopening highs reached over the past few quarters,” Roach noted. Overall, though, she emphasized that her outlook on stocks tied to the economic recovery remains favorable, with the understanding that there may be a few bumps along the way as global central banks work to calibrate monetary policy.