No Rate Hike & Dovish Guidance

As expected, the Fed didn’t raise rates on Wednesday. Furthermore, as you can see from the chart below, guidance calls for no rate hikes through 2023. Just 3 members see hikes in that year, but that doesn’t mean much. Technically, we could have a new chair by then, but most don’t think the new chair or new members will have different worldviews from the current Fed.

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Trend is towards being more comfortable with higher inflation which is ironic because we haven’t gotten much inflation recently. Fed is comfortable with the ghost that is sustainable core 2% or higher inflation. Some think the Fed might hike rates in 2023. Even if that ends up happening, the Fed probably wouldn’t guide for that until late next year at the earliest.

If the recovery goes the way many think it will, we will have a sharp decline in unemployment as the COVID-19 tests allow the economy to go back to normal. Inflation will be boosted by the increase in wage costs along with the fact that commodity production has suffered. A cure for low commodity prices is low prices because it lowers supply. It will take a few quarters to get supply going again. That’s why oil can reach $80 per barrel in the next upcycle.

Changes To Fed’s September Statement

Fed’s first change to its statement showed more optimism as it went from “Following sharp declines, economic activity and employment have picked up somewhat” to “Economic activity and employment have picked up.” Getting rid of the word “somewhat” is pivotal. The rate of economic improvement has fallen, but on an absolute basis in the past 2-3 months, the economy has gone from being in a bad recession to early signs of a normal recovery.

Technically, the economy probably wasn’t in a recession in May and June, but the deepness of the economic decline was so bad, that on an absolute basis the economy was as bad as a recession. A recovery has been going for many months, but finally, we’re starting to see enough improvement in the labor market for this to look like a regular recovery. 

Specifically, above 10% unemployment normally isn’t a recovery, while 8.4% unemployment looks like the start of a normal recovery after a bad recession. Fed also said the “health crisis will continue to weigh on economic activity” instead of “weigh heavily.” With the unemployment rate falling sharply, it’s clear the economy isn’t in a recession.

There was a massive adjustment to the new paragraph it added this year. A key part of the new paragraph is that “the Committee will aim to achieve inflation moderately above 2% for some time so that inflation averages 2% over time and longer run inflation expectations remain well-anchored to 2%.” This change reflects the sentiment pursued in Powell’s Jackson Hole speech a few weeks ago.

New Median Fed Projections

This was an important meeting because the Fed updated its economic policy projections. The table below shows them. The last update was in June. Fed lowered its estimates for real GDP growth in the next 2 years from 5% and 3.5% to 4% and 3% as the impact of the COVID-19 crisis was less than feared, so there will be a smaller reversal in the future. Or you can say the Fed now sees the V-shaped recovery moderating which it is using to make 1-2 year projections. 

A slower recovery rate is because COVID-19 is still limiting growth and because the stimulus is gone. If the Dems win in November, we might see a stimulus in 2021. Also, keep in mind, we could see another V-shaped recovery in Q4 if testing lets the economy go back to normal.

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There was a massive decline in the Fed’s projection for the unemployment rate in 2020 because of the big decline in the past few months. Once again, the Fed underestimated the improvement in the labor market. This projection went from 9.3% to 7.6%. 

A couple of months ago, it was predicted the unemployment rate would fall below 8% by the end of the year. Fed also sees the average unemployment rate in 2021 falling to 5.5% instead of 6.5%. That’s closer to full employment, but not there yet. In 2022, it expects the unemployment rate to fall to 4.6% which is 0.9% lower than its June projection.

It added its 2023 projection for 4% unemployment. Fact that the Fed doesn’t plan to raise rates despite the projection for 4% unemployment tells us the Fed doesn’t see that as full employment. It sees a U3 rate having a 3 handle as full employment which necessities hiking rates. If a 4% unemployment rate doesn’t cause the Fed to hike rates, we’re getting close to the Fed saying it will never raise rates.

On the other hand, the Fed sees core PCE inflation of 1.8% in 2022 and 2% in 2023. If inflation only barely hits its target in 2023 after years of staying below 2%, there is no need to hike rates. Obviously, the main variable here is inflation. It could easily miss that target or get above the target. 

Investors can see commodity prices rising in 2021 and 2022 along with wage inflation as the labor market gets tighter. That’s why the 10-year yield will likely hit 1% within the next 11 months.

Conclusion

Fed gave us exactly what was expected. It’s almost impossible for the Fed to be anymore dovish unless it goes as far as saying it won’t ever hike rates no matter what. Contrarians see core PCE inflation picking up next year and in 2022. Furthermore, they see the 10-year yield rising modestly in the near term. We are at a cyclical low point for yields.