The Big Idea

Connecting the dots

Stephen Stanley | March 19, 2021

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The Fed’s latest summary of economic projections and Chair Powell’s comments at his press conference start to sketch the Fed’s expectations for monetary policy over the next several years. Futures markets and economists’ projections point to a modestly faster path for liftoff. But even that may be too slow. Tapering looks likely to begin as early as October this year with the first Fed rate hike coming as early as spring 2022.

Setting the agenda

A projected timeline for Fed policy normalization starts with the order of events. For the most part, it appears the Fed would like to roughly follow the sequence from the last normalization cycle. That points to a probable series of steps:

1. Talk about tapering
2. Initiate tapering
3. End asset purchases but maintain the size of the balance sheet
4. Liftoff on the fed funds target rate
5. Allow balance sheet runoff.

The only ambiguity here would be the order of the final two steps. In the prior cycle, the FOMC lifted off in December 2015 but did not begin shrinking the balance sheet until late 2017, after four fed funds hikes. In theory, the FOMC could decide to begin shrinking the balance sheet before lifting off in the current cycle, especially considering how large the balance sheet will be by the time it peaks. However, the order will probably be the same as last time. The FOMC in the 2010s expressed a strong preference to leave the balance sheet steady until it was sure the economy was out of the woods and a return to the zero bound looked unlikely any time soon.

Filling in FOMC preferences

The FOMC offered projections for its fed funds rate target in the dot estimates, but clues to the other four steps come from some of the statements from Powell and others on the committee. Official forward guidance says the Fed would need to see “substantial further progress” toward its dual mandate goals before beginning to curtail asset purchases. Powell emphasized at his press conference a need for actual rather than projected improvement.

Substantial further progress might mean something like narrowing half the employment gap from December 2020, when the guidance was introduced, to full employment, along with at a minimum significant movement toward 2% on the inflation front. That would imply an unemployment rate in the low 5%s or a cumulative rise of close to five million for payroll employment or both. But officials may be looking for even more strengthening than that, perhaps closing about 75% of the December 2020 gap. Inflation is going to be tougher to gauge because the Fed is already promising to ignore the short-term run-up in year-over-year inflation likely over the next three months to six months.

Judging from the FOMC’s latest economic projections, the median estimate of the unemployment rate for the fourth quarter of this year is 4.5%, which would be awfully close to the Fed’s estimate of full employment. But many Fed officials seem to believe labor force participation will recover more slowly than hiring and the unemployment rate will continue to understate the degree of slack in the labor market. On the inflation side, the FOMC looks for a temporary burst in prices to 2.4% by late this year followed by a moderation back to roughly the 2% target in 2022 and 2023.

It is also important to note that Powell and others at the Fed have talked about a very leisurely pace of normalization. The Fed believes that it will be “some time” before we reach “substantial further progress,” which will give Powell ample opportunity to alert financial markets well before a taper is announced. Then, several officials have indicated that the pace of tapering might be similar to the last cycle, when the first taper was announced in December 2013 and asset purchases did not end until October 2014. Subsequently, it was over a year later before the Fed lifted off, moving the fed funds rate target off of the zero bound. The FOMC still believes liftoff will not occur before 2024, as 11 out of 18 committee members kept their end-2023 dot at 0.125%.

Piecing these elements together, a timeframe for policy normalization might look like this:

1. Talk about tapering: Late summer or fall 2021
2. Initiate tapering: Early 2022
3. End asset purchases: End 2022 to early 2023
4. Liftoff: 2024.
5. Allow balance sheet runoff: 2024 or later.

As Powell emphasized at his press conference, the Fed’s forecasts for 2023 and further are not of any particular value. If the economy surprises, the Fed’s policy projections will adjust. Having said that, the juxtaposition between the FOMC’s quite optimistic economic projections and its dot estimates are a striking declaration of dovishness. The FOMC is forecasting that at the end of 2023, the economy will have been operating beyond full employment for over a year, with inflation at or above its 2% target for three years—accepting that the FOMC is shooting for modestly above-target inflation for a time—and the Fed would still be maintaining the funds rate at the lower bound. That reflects a radically new monetary policy framework. By comparison, at liftoff in December 2015, the unemployment rate was above 5% and inflation was far below 2%, with the core PCE deflator running at 1.2% year-over-year and not accelerating.

Market pricing

Figuring out market pricing for rate hikes is a little tricky since they are likely so far out in the future. Fed funds futures do not trade much beyond 18 months. Eurodollar futures have been the traditional tool for determining market expectations for the Fed beyond a year or so, but with the LIBOR transition, it is not entirely clear if we should take the reds (the second year out) and greens (the third year out) literally. For what it is worth, the Eurodollar futures start to inch up noticeably in late 2022, pricing in part of one rate hike by the end of 2022 and then about 60 bp of rate increases in 2023, before addressing the nuances of term premia. SOFR futures are a relatively new and unproven metric with less trading volumes than Eurodollar futures at the moment, but they offer a third look into the future. SOFR 3-month futures currently have about 18 bp of increases in 2022 and another 55 bp in 2023, very consistent with Eurodollar futures.

Futures imply that market participants are somewhat less dovish than the FOMC, expecting the possibility of a move by the end of 2022 and perhaps a total of two to three quarter-point moves by the end of 2023.

Consensus of economists

Bloomberg conducted a survey of 41 economists shortly before this week’s FOMC meeting. The responses offer a clear picture of how economists expect the steps of normalization to play out. Most expected tapering to begin in either the last quarter of 2021 or the first quarter of 2022 and to last between seven months and 12 months. As for liftoff, the median estimate had the FOMC sticking to the lower bound through the end of 2022 but raising the funds rate by almost 50 bp in 2023. Economists are generally in sync with financial market participants on the timing of rate hikes and appear to be broadly following the FOMC’s guidance on the timing and pace of tapering.

My Projections

As has been the case since the early days of the pandemic, my economic forecasts are more optimistic than the FOMC’s. The latest SEP projections propelled the Fed to a more upbeat outlook than the private sector consensus, but my own projections are still more aggressive than the Fed’s. For example, I expect 8% real GDP growth this year (the Fed is at 6.5%), and I expect the unemployment rate to average about 4.25% in the fourth quarter of this year (the FOMC is at 4.5%). Perhaps most importantly, I look for inflation to accelerate further above 2% later this year than the FOMC does, and I expect inflation to remain noticeably above 2%, even after the temporary reopening burst in prices recedes.

With that as context, it should not be surprising that my timeframe for policy normalization is faster than the FOMC’s (or the private sector consensus). I believe that the recovery will be violent in the spring and summer of 2021, convincing the FOMC that “substantial further progress” has been achieved well before the end of the year. In fact, I look for an initial taper to be announced at the September FOMC meeting, to be implemented in October.

One of the most important distinctions that I would make between my forecasts and those of the FOMC is that I find the reliance on the last cycle as a template to be wholly inappropriate. Economic growth was sluggish and inflation was mostly below target during that period, allowing for a leisurely pace of normalization. In contrast, the economy, propelled by reopening from the pandemic restrictions and by unprecedented amounts of fiscal and monetary stimulus, is likely to rocket ahead in 2021 and 2022, which should require a quicker progression through the steps laid out above. I would expect the tapering process to be much shorter than in 2014, perhaps six months or less. Moreover, by the time the FOMC stops buying assets, in early 2022, the unemployment rate may already be in the 3%’s, signaling an economy operating beyond full employment (I also expect that labor force participation will have retraced the pandemic drop by then), and in stark contrast to the late 2010s, inflation as measured by the headline and core PCE deflators may be running well above 2%, perhaps in the 2½% neighborhood. Therefore, I look for the FOMC be forced to very quickly transition from tapering to rate hikes, perhaps lifting off as early as spring 2022.