Market Outlook Fed Watch Part 2

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Richard Vermeulen
May 12, 2022

The Federal Reserve continues to manage through the current turning point in its history. The unprecedented monetary and fiscal stimulus injected into the economy at the onset of the pandemic has had a rapid effect on financial markets, successfully preventing a sudden recession and hardship in the economy. After many months of stimulus, the rapid removal of that stimulus is required to halt the opposite effect of price spirals and excess demand. Timelines for the end of the stimulus are now being set out. Responsiveness to economic realities is part of the “new normal”, so, as events continue to unfold over the course of this year, significant moves by both monetary and fiscal policymakers will occur.

Construction, particularly residential and infrastructure, is a sector of the economy that could experience a positive long-term structural shift, much as other sectors could see long-term declines, due to the realities of a post-pandemic world.

Below are bullet point interpretations of the March 16 press conference with Federal Reserve Chair Powell.

GDP and job growth strong – growth projection for this year reduced from 4%

“Economic activity expanded at a robust 5½ percent pace last year, reflecting progress on vaccinations and the reopening of the economy, fiscal and monetary policy support, and the healthy financial positions of households and businesses. The rapid spread of the Omicron variant led to some slowing in economic activity early this year. But cases have declined sharply since mid-January, and the slowdown seems to have been mild and brief. Although the invasion of Ukraine and related events represent a downside risk to the outlook for economic activity, FOMC participants continue to foresee solid growth. As shown in our Summary of Economic Projections, the median projection for real GDP growth stands at 2.8 percent this year, 2.2 percent next year, and 2 percent in 2024.”

The Fed sees inflation in a broader range, bottlenecks remain

“Inflation remains well above our longer-run goal of 2 percent. Aggregate demand is strong, and bottlenecks and supply constraints are limiting how quickly production can respond. These supply disruptions have been larger, and longer lasting, than anticipated, exacerbated by waves of the virus here and abroad, and price pressures have spread to a broader range of goods and services. Additionally, higher energy prices are driving up overall inflation. The surge in prices of crude oil and other commodities that resulted from Russia’s invasion of Ukraine will put additional upward pressure on near-term inflation ere at home. The inflation projection is 4.3 percent this year and falls to 2.7 percent next year and 2.3 percent in 2024; this trajectory is notably higher than projected in December, and we continue to see risks as weighted to the upside.”

Interest rates are set to rise to 1.9% by end of 2022, increasing from previous

“The median projection for the appropriate level of the federal funds rate is 1.9 percent at the end of this year—a full percentage point higher than projected in December. Over the following two years, the median projection is 2.8 percent—somewhat higher than the median estimate of its longer-run value.”

The Fed will now tighten quantitative measures

“At our meeting that wrapped up today, the Committee made good progress on a plan for reducing our securities holdings, and we expect to announce the beginning of balance sheet reduction at a coming meeting.

As of March 16, the Fed saw the invasion of Ukraine affecting the recovery

“In addition to the direct effects from higher global oil and commodity prices, the invasion and related events may restrain economic activity abroad and further disrupt supply chains—which would create spillovers to the U.S. economy through trade and other channels. The volatility in financial markets, particularly if sustained, could also act to tighten credit conditions and affect the real economy..”

The probability of a recession is not elevated

“Aggregate demand is currently strong, and most forecasters expect it to remain so. The labor market is also very strong. Conditions are tight, and payroll job growth is continuing at very high levels. Household and business balance sheets are strong. And so all signs are that this is a strong economy and, indeed, one that will be able to flourish in the face of less accommodative monetary policy.”

The Fed forecasts goods and services inflation trending down - their other main watches are wage levels outpacing productivity growth, and rent (owner equivalent rent) inflation

“Wages are not a big part of the high-inflation story that we're seeing, but if you had something where wage increases were persistently above productivity growth, that puts upward pressure on firms, and they raise prices. It's something that we're watching. Wage increases, which are now running above the level that would be consistent over the long run with 2 percent inflation, will move back down to levels which are still very attractive full-employment kind of wages, but not to a point where they’re pushing up inflation anymore. And the other thing, of course, is the owners' equivalent rent. Unlike the things that are causing the inflation now, this is economically sensitive—and so would be expected to move up.”

The labor market is tight which points to restricting policy

“Labor force participation, the unemployment rate, and wages, that's really one of the great signals. The quits rate is one of the very best indicators because people quit because they feel like they can get a better job. What you have is 1.7-plus job openings for every unemployed person — tight to an unhealthy level. If you were just moving down the number of job openings so that they were more like one to one, you would have less upward pressure on wages. We’re hearing from companies that they can’t hire enough people. We’d like to slow demand so that it’s better aligned with supply; give supply, at the same time, time to recover; and get into a better alignment of supply and demand.“

Real interest rates will come down as inflation cools and nominal rates rise

“Couched it in terms of real rates we are getting close to or even above, in many cases, our estimate of the longer-run neutral rate. So while that doesn’t do it for current real rates, if you go out a year or two, our forecast is tight policy from a real interest rate standpoint.”

Richard Vermeulen

Richard Vermeulen
Senior Principal

Richard has been in the industry for over 3 decades. He is the creator of the Quarterly Market Outlook and chairs the Vermeulens Forum.

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