EC Discounting Policy Errors

This is important because it underscores our understanding of what is driving the dollar. Its broadest expression is that the large budget and trade deficits require higher interest rates, or the dollar bears a greater burden of the adjustment process. The Vice-Chairman of the Federal Reserve Clarida reiterated the Fed's position. He said that after the disappointing April jobs report means that the threshold to tapering ("significant further progress" toward the Fed's targets) has not been met.  

That means the Fed continues to buy $80 bln a month of Treasuries and $40 bln a month in mortgage-backed Agency bonds. There will be another nonfarm payroll report before the FOMC's June 15-16 meeting. The early call is for around 600k gain. Even if it were a million, it would not spur the Fed into action.  As we have noted before, the market sees the KC Fed's Jackson Hole symposium (typically late August) and the September FOMC meeting as a window of opportunity to recalibrate the Fed's balance sheet expansion. And surveys show that this was the expectation before the release of the April FOMC minutes. 

A year ago, we argued that if the Fed were to pull back from its balance sheet expansion, US interest rates would fall because the economy would weaken without the buying. However, now it is a different story. The economy is in a different place. Fiscal policy is fully engaged. The vaccine is allowing a re-opening of the economy, albeit in an uneven way. Thus, if the Fed were to taper its purchases, it would signal recognition of the strength of the US economy that no longer required as much extraordinary monetary policy, and rates would likely rise.   

If the market thought the Fed was making a policy mistake, where would one look? The majority of the Fed did not think a rate hike would be appropriate until after 2023 in the March economic projection exercise. The market thinks otherwise. The December 2022 Eurodollar futures contract, for example, has largely discounted a rate hike by the end of next year, more than a year earlier than the Fed signals. The 10-year breakeven has been above 2.4% since the end of April. The five-year five-year forward has been above 2.3% since the end of March. The University of Michigan's survey of long-term consumer inflation expectations (5-10 years) is above 3% for the first time in a decade.  

Fed officials recognize the importance of anchoring inflation expectations. However, reasonable people can observe these measures of inflation expectations and conclude that inflation expectations have become unanchored. Fed Chair Powell explained that "The fundamental change in our framework is that we're not going to act pre-emptively based on forecasts for the most part, and we're going to wait to see the actual data."  

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Read more by Marc on his site Marc to Market.

Disclaimer: Opinions expressed are solely of the author’s, based on current ...

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