Did the Fed Turn Hawkish?

The US central bank maintained its interest rates and QE pace last week, but upgraded its economic forecasts and view on rates path, sending the US Dollar higher. Before we delve into that, lets take a look at the bank's role, functions and recent history.

The Federal Reserve

The Federal Reserve (Fed) is the central bank of the United Sates, which was created under the 1913 Federal Reserve Act, to provide the nation with a safer, more flexible, and more stable monetary and financial system. The Fed is entrusted with the responsibility to achieve maximum employment, stable prices, and moderate long-term interest rates in the United States.

The bank discharges these duties by setting the monetary policy via the Federal Open Market Committee (FOMC), in eight regularly scheduled meetings per year.

The Federal Open Market Committee consists of twelve members - the seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis.

The central bank's current chairman is Mr Jerome Powell, who succeeded in 2018 the now Secretary of the Treasury, Mrs Janet Yellen.

Recent History

The bank sets monetary policy in order to achieve stable prices and maximum employment. The implicit inflation target, has been around 2% since 1996 and in 2012 Mr Bernanke made it an official goal.

In August 2020 at the Jackson Hole Symposium, Mr Powell revised this goal, as he announced that policymakers will be henceforth aiming at an average inflation target (AIT) of 2% over the long-run. The new framework means that the committee will tolerate inflation above its target for a period of time to offset periods when inflation was below its target.

The Fed made this shift in order to give itself more flexibility to sustain the monetary stimulus programs and the near zero interest rate policy it implemented in order to combat the economic shock of COVID-19.

What did the Fed Decide on Last Wednesday?

The central bank kept interest rates to their effective lower bound of 0-0.25% and its asset purchases at $120 bln/month as expected, without making any important changes to its policy statement.

What market participants were mostly looking forward to, was for any indication as to when the bank will begin tapering its Quantitative Easing program (QE), However, It did not offer any timeframe, with Mr Powell commenting during his press conference that "You can think of this meeting that we had as the 'talking about talking about' meeting, if you'd like".

Furthermore, the Fed revised its inflation forecast significantly higher for 2021 - now seeing Core PCE at 3.0% (compared to 2.2% of the March projections) – and modestly higher for 2022 (at 2.1% vs 2.0 in March).

The hawkish surprise came from the "dot-plot" in which the Fed officials express their view on the path of interest rates. This now puts the rate lift-off date in 2023, showing not only one, but two hikes in that year. Back in March, officials did not see any rate increase through the end of 2023.

This caused the US Dollar and Treasury Yields to soar, while Wall Street declined.

So does this constitute a hawkish shift for the Fed? This is probably a bold claim. It seems more like a shift from a hyper-dovish stance to only a slightly dovish one. Although the central bank acknowledged that inflation has been coming in higher than anticipated, it reaffirmed its view that this is transitory. Moreover, the dot-plot is not an official policy and Mr Powell downplayed its significance, saying that "dots to be taken with a big grain of salt"

If the previous QE tapering/rate hike cycle is seen as guide, the dot-plot upgrade looks to us more like a realistic adjustment of the projected rate path. The bank formally announced the winding down of its quantitative easing program in December 2013 with a start date of January 2014 and the first rate increase followed in December 2015.

What's Next?

The second half of the year is going to be a difficult one for the central bank, as it needs to consider normalizing its ultra-loose monetary policy in order to avoid overheating the economy, without pulling its support too early and cause the recovery to falter.

Over the coming months, the Fed will likely try to signal the scaling down of its asset purchases, without roiling the financial markets.

Fed officials have learned their lessons from the 2013 "Taper Tantrum" and are making sure that they have a very long runway to land any QE reduction and communicate such a move well in advance. Back then, Mr Bernanke had suggested that the Fed may taper the bond-buying program (QE) it had implemented to combat the 2007-2008 Financial Crisis, which caused US Treasury Yields to spike and the stock market to dip.

We believe that so far Mr Powell has done a good job in the face of inflationary pressures, of taming market expectations and showing the bank's commitment to supporting the economy.

However, If high inflation prints continue coming, economic activity continues to strengthen and the labor market makes progress, they will put pressure on the Federal Reserve, test its resolve to continue its stimulus and perhaps even cause it to second-guess its transitory view about prices.

Nikos Tzabouras

Nikos Tzabouras

Senior Market Specialist

Nikos Tzabouras is a graduate of the Department of International & European Economic Studies at the Athens University of Economics and Business. He has a long time presence at FXCM, as he joined the company in 2011. He has served from multiple positions, but specializes in financial market analysis and…

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