We at Fitch Solutions maintain our forecast for the US fed funds target rate to remain at the zero lower bound until 2023.
A recent rise in inflation has brought the Fed's projections for rate hikes forward from 2024 to 2023, in line with our view and those of the markets.
The shift in the Fed's outlook suggests that risks are weighted toward an earlier start to rate hikes, given concern over a potential rise in medium-term inflation expectations.
We at Fitch Solutions maintain our expectation that the US Federal Reserve (Fed) will hold the fed funds target rate at the zero lower bound until 2023. On June 16, the Fed kept its benchmark rate at 0-0.25% and repeated its commitment to continue purchases of Treasuries and mortgage-backed securities over the coming months in order to support market functioning, marking no change in policy. The decision was in line with our view and that of market expectations.
Interest Rates To Remain At Zero Until 2023
US - Fed Funds Rate, %
The Fed's decision reaffirmed that it is seeking inflation above its 2.0% target for a period of time in order to allow for a strengthening of the labour market, which has yet to stage a full recovery from the pandemic-induced recession. Headline unemployment stood at 5.8% in May, well above the sub-4.0% level that prevailed prior to the pandemic, and Fed officials continue to emphasise their belief that these figures understate the decline in employment due to a drop in labour market participation (61.6% in May, down from above 63.0% prior to the pandemic). We expect unemployment will fall to 4.6% by end-2021 and 3.9% at end-2022. These forecasts are in line with the Fed's projections and underpin our view that the Fed will wait to observe improvement in the labour market before altering its policy stance.
Labour Market Will Steadily Trend Toward Pre-Pandemic Levels
United States - Unemployment Rate, %
That said, the Fed's economic projections show a move forward in policymakers' anticipated timeline for a shift to rate hiking. In the Fed’s ‘dot plot’ the median projection for the fed funds rate now suggests rate hikes beginning in 2023, in line with our view and that of markets, rather than the previous 2024 projection. Additionally, seven out of 18 FOMC participants now expect rate hikes as early as 2022, up from four previously. The revision reflects a gradual shift in public commentary from FOMC members and other officials close to the Fed. Several members mentioned in recent weeks that the FOMC could start discussing tapering in the coming months, and Treasury Secretary Janet Yellen, who does not participate in setting Fed policy, said higher interest rates could be a ‘plus’ for the US.
|Change in real GDP||June||7.0||3.3||2.4||1.8|
|Fed funds rate||June||0.1||0.1||0.6||2.5|
We believe the shift in the Fed’s economic projections is being driven by concerns over inflation, which we previously highlighted as a likely test of the Fed's new policy approach. Although policymakers continue to see the recent rise in inflation as transitory, inflation has outpaced expectations over recent months amid persistent supply chain bottlenecks for select goods such as energy, cars and lumber. US consumer price inflation came in at 5.0% y-o-y in May, which was above consensus expectations of 4.7% and up from 4.2% in April. We continue to expect that price pressures will ease over the coming months as supply chain bottlenecks ease (lumber prices, for example, have fallen over recent weeks), but the recent rise in prices now puts our end-2021 CPI forecast at 3.9% y-o-y. The Fed, which uses a separate measure of inflation, revised up its year-end inflation forecast to 3.4% in 2021, from 2.4% previously.
Average Inflation To Rise Above 2.0% Target
US - Fed Funds Rate & Consumer Price Inflation, %
Bond markets are pricing a hike between Q123 and Q223 (see chart below), but do not seem overly concerned by inflation. The US 10-year bond yield is at 1.57% currently, but remains below its late March 2021 high of 1.75%. Inflation expectations, as proxied by 10-year breakevens, have nonetheless continued to edge lower, at 1.4%. While the US yield curve flattened slightly following the announcement, it reflect higher rates in the 2-10 year range.
Odds For A First Interest Rate Hike By The Fed Firming Up
United States - Fed Funds Futures Curve, %
Risks are weighted toward an earlier start to the rate hiking cycle. As noted, a small but growing number of FOMC members now foresee a start to tightening in 2022, and in his press conference following the announcement Fed Chairman Jay Powell noted concern that inflation expectations could feed observed inflation. Although Powell has continued to emphasis the Fed's focus on labour market indicators, the shift in the Fed's rates outlook due to the recent uptick in inflation suggests that it remains sensitive to the potential for a transitory rise in inflation to become sustained.
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