Economic Update QuarterlyLawry Knopp, VP-Funding & Hedging
- Currently, three factors are exerting significant influence on the markets: monetary policy, the runup in inflation and fiscal policy. The first two are related, in that the Federal Reserve tries to influence inflation by either tightening monetary policy (raising rates) or loosening policy (lowering short-term rates). Fiscal policy has had greater impact on the economy over the past 15 months as the Federal government injected about $5 trillion of fiscal stimulus support into the economy during the COVID-19 pandemic.
President Biden recently announced an agreement had been reached between the administration and members of Congress on a bill with a price tag of almost $1 trillion. The legislation includes over $500 billion in new spending. With the progress achieved on getting approval, the administration is hopeful it will help facilitate the president’s more than $4 trillion in spending proposals for what the White House refers to as “human infrastructure.”
- Federal Reserve policymakers whipsawed the markets last week as the U.S. 2-year Treasury yield jumped 10 basis points after the Federal Open Market Committee signaled a hawkish pivot to possibly tightening monetary policy rates sooner than expected. The 10-year Treasury yield was volatile but is nearly unchanged since then. The major U.S. equity indexes are slightly higher after a few days of volatile trading.
The Committee provides economic projections four times a year. Comparing the March FOMC Summary of Economic Projections to the June summary, several members moved up their projected timeframe for beginning to increase rates. In the March survey, most of the participants projected no increase in rates until after 2023. For June, a majority of the participants forecast the first rate increase in 2023 with seven out of 18 members projecting a rate hike in 2022.
A difference of opinion over how temporary the recent runup in inflation will be is largely responsible for the shift in policy expectations. Several Federal Reserve officials continue to argue the recent rise in inflation is transitory and the market should look past signs of shortages and wage and price pressures. While some of the recent price increases can be expected to mean revert, the ability of supply chains to ramp-up to meet demand will likely take longer to resolve. The reality is businesses are contending with higher input costs, longer lead times for inventory, shipping delays and shortages of skilled labor. This remains a challenging time for producers as they must correctly assess how much to invest to meet both current demand and what will be sustained going forward.
Another complication is the weakness in the dollar, which erodes purchasing power for foreign goods and imports inflation. As the global economy has recovered, demand for the safety of dollars has lessened as investors have been willing to add more risk to their portfolios and invest capital in other global economies. Monetary policy can also influence currency values with higher rates being more attractive to foreign investors and vice versa.
- We saw a significant increase in consumer inflation for April, which continued in May. In April, the Consumer Price Index (CPI) rose by 0.8% month over month, the largest increase since 2009. The May report indicated year-over-year consumer inflation accelerated to 5%, the highest reading since June 2008. The main contributors to this increase are related to easing restrictions, surging demand and shortages. Increasing numbers of vaccinated people and relaxed mask and social distance requirements are allowing people to feel like we are returning somewhat to normal. We’re seeing increased activity with more folks eating out and people willing to fly for vacations and business travel. Prices are returning to pre-pandemic levels, and in some cases higher, which is being reflected in the year-over-year calculations for food away from home, auto rental prices and airline fares. The improved economic outlook and cuts in production have pushed oil prices higher with the price for West-Texas Intermediate crude, nearly doubling in the last 8-9 months. Shortages of key manufacturing components, such as semi-conductors, have developed due to trade and national security disputes while some countries where production is focused are now experiencing serious COVID-19 outbreaks. This is driving up the cost of used autos as production of new vehicles has slowed. Federal Reserve Chair Jerome Powell says these types of price increases are temporary and supply chains and production capacity are expected to adjust to meet increased demand, which should ease pressure on prices. However, other components of inflation may not adjust down as quickly or may remain elevated, such as recent increases in wages, which is a concern for producers and businesses.
So far, response to the higher inflation numbers has been muted with longer-term interest rates well below the year-over-year inflation numbers. This indicates the market is likely in agreement with the Fed and anticipates price pressures will subside within the next several months. If inflation remains elevated longer than expected, the Fed’s credibility may be questioned and the FOMC may be required to hike interest rates sooner than later. So far, the market appears to be in a wait-and-see mode.
- The Fed is expected to begin trimming quantitative easing (QE) purchases before implementing an increase in rates. Rising inflation and an expected Q2 GDP growth rate of around 10% could generate more conversation around when to start tapering QE. Provided inflation pressures begin to ease and stimulus-fueled GDP growth remains within the Fed’s comfort zone, QE reductions could begin sometime in early 2022. If the market begins to feel the economy is starting to overheat, the Fed may be forced to tap the policy brakes sooner and harder than expected to reassure investors and traders
- On July 31, 2021, the current suspension of the Federal debt ceiling will end. Unless the debt ceiling is raised or suspended again, the U.S. Treasury would be forced to employ special measures to avoid breaching the limit and defaulting on debt payments. Treasury Secretary Janet Yellen would like Congress to start the process of increasing or suspending the limit as soon as possible as Congress may not be in session in August. In the past, market volatility has been elevated, especially in shorter-term rates, as Congress and brinksmanship delayed the process of addressing the limit to the eleventh hour.
Interest Rates Review
|U.S. Treasury Yields||
With Federal Reserve monetary policy expected to be on hold for the next 12-24 months, look for the 2-year U.S. Treasury yield to remain below 0.4% for 2021 with the potential for the top of the trading range to increase to 0.6% during 2022. The current yield is near the top of the 6-month trading range of 0.11%-0.27%. As fiscal and monetary stimulus eclipse all previous policy efforts, the range for the 10-year Treasury yield is much wider at 0.91%-1.75%. Look for the 10-year trading range to trend higher with the upper bound potentially breaking above 2% later this year on the prospect for stronger economic growth and higher inflation.
Gross Domestic Product: The third estimate for Q1-2021 GDP growth reported stronger growth for consumer and business spending and housing. Growth in inventories remained negative, but at a slower rate while net exports continued to be a drag on growth. In real dollar terms, the economy expanded by $292 billion to $19.09 trillion on a seasonally adjusted annualized rate. Overall, the report suggests solid growth for the medium-term while President Biden and Congress seek to pass more fiscal stimulus packages. COVID-19-related stimulus now totals about $5 trillion.
Experts are expecting President Biden to propose significant tax increases starting with an increase in the corporate tax rate to 28% by year-end. Expect increases in personal taxes and new social taxes in 2022, which may hurt growth in 2023 as fiscal policy tailwinds start to fade.
Consumer Price Index: Consumer inflation for May rose by 0.6% month over month, while core consumer price inflation increased 0.7%. There was a modest increase in food prices, up 0.4%, while gas prices fell 0.7%. Compared to a year ago, overall inflation is up 5% with food prices up 2.1% and gas prices up 56.2%. Core inflation, which excludes food and energy components, is higher by 3.8%, the highest it’s been since 2008. Housing, a significant component of the CPI complex is up 2.9%. The base effect related to the year-over-year calculation of the index will exert upward pressure on the index for the next few months and then should start to dissipate. However, inflation is expected to remain elevated as the economy adjusts to COVID-19 restrictions being lifted and a surge in demand, shortages of labor and massive fiscal and monetary stimulus.
U.S. employment improved as nonfarm payrolls for May expanded by 559,000. The unemployment rate fell 0.3% to 5.8% as household employment expanded and the labor force contracted slightly. Leisure and hospitality led gains with contributions from education and health care. Although gains in nonfarm payrolls was decent, it was still less-than-expected and may be a sign business are having difficulty finding employees. Over the last six months, average hourly earnings have grown at an annualized pace of 4.5%, well above pre-pandemic levels of 3%-3.5%. These wage gains are exceptional, but it is too early to determine if the higher wages will be sustained longer than previously thought.
At the conclusion of the June 15-16 Federal Open Market Committee meeting, policymakers decided to keep the target range for the federal funds rate at 0.0%-0.25%. Monetary policy rates are expected to be relatively unchanged for the next 12-24 months as the Fed operates under its new “flexible average inflation targeting” (FAIT) regime. The Fed’s dual policy mandate of stable prices and maximum sustainable employment will remain the focus for policymakers. The Fed lifted its forecasts for growth and inflation and lowered the projections for unemployment. The market viewed the shift in the “dot plot” as more hawkish as several committee members moved up their timing for the first increase in policy rates, which in the past Fed Chair Jerome Powell has said the dots were forecasts only. Chair Powell continued to signal monetary policy would remain accommodative until inflation is consistently above 2% and expected to average 2% on a sustained basis while the economy achieves maximum employment. Quantitative easing purchases of Treasury and mortgage-backed securities will continue at a rate of $120 billion per month.
View on Interest Rates
Look for the Fed to keep policy rates at the current level until 2023, provided inflation remains within the Fed’s new strategic framework. The expected increase in inflation over the next several months will likely be tolerated if it falls within the Fed’s new average inflation targeting regime and policymakers believe the uptick is temporary. The FOMC will continue to focus on providing support to the financial markets through purchases of Treasury and agency mortgage-backed securities at a rate of $120 billion per month. If longer-term Treasury yields continue to move higher, this may present new and more difficult challenges to the Fed’s desire for yields to remain low.
The 2-year yield will likely remain below 0.40% for most of 2021. The 10-year yield trading range is expected to be 1.20%-2.20% for the next two to three quarters. If the equity markets were to experience a sell off, flight-to-safety trading could push U.S. Treasury yields lower and the dollar higher.
Market volatility has subsided over the past several months as the U.S. economy and markets seek a return to normal operations. The threat to the economy has subsided as the Federal government pumps substantial amounts of fiscal stimulus into the economy. Northwest FCS has been able to meet customer needs through the challenges of the outbreak and expects to continue doing so as people deal with the dynamics of the virus. The association remains watchful for potential threats that may arise as government officials work to mitigate the effects of the virus and keep people safe.
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