The Fed’s Great Experiment Now In Progress

The revival in economic growth expectation for this year’s first quarter is also juicing forecasts of higher inflation. As reported yesterday, Q1 GDP nowcasts have ramped up sharply in recent weeks.

The embedded assumption in the Fed’s policy of letting inflation run hotter while leaving extraordinarily easy monetary policy unchanged: reflation will be modest and temporary and pricing trends will soon return to pre-pandemic levels and stop there. Deciding if that’s an accurate forecast will take time. Perhaps by the second half of 2021, the markets will have clear visibility of the wisdom (or lack thereof) of this assumption.

Meantime, markets are inclined to demand some degree of insurance if the central bank is wrong – a hedge in the form of higher yields on the long end on the curve. On the short end, by contrast, the markets appear confident (for now) that the Fed will keep its promise to forgo rate hikes.

Consider the 2-year Treasury yield, which is widely considered to be the most sensitive maturity for rate expectations. Despite the run higher in the 10-year rate, the 2-year yield continues to hold steady in a tight range that’s near its pandemic lows.

The 2-year rate’s implied forecast — that the Fed will leave its current zero-to-0.25% target range extend for the foreseeable future — finds support in Fed funds futures, which are pricing in a near-zero probability of a rate hike through the end of this year.

The question is whether letting reflation run hotter for longer risks letting the cat out of the bag? No one knows at this point, but clarity is coming. Meantime, the decades-long run of disinflation isn’t easily dismissed since the key forces driving the trend remain (aging workforce, savings glut, rising technology-related disruption/efficiency, etc.) remain in place and don’t appear set to disappear.

Nonetheless, thinking through the implications of what could go wrong with the Fed’s experiment is topical for 2021. The stakes are certainly high for markets and the economy, which are effectively leveraged to low-interest rates.

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Disclosures: None.

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