Fed preview: Hawkish tweaks

• This week the Federal Reserve is set to keep its very dovish stance but may start talking about when to taper its quantitative easing and tweak its forecasts of future interest rate hikes.
• The Fed will leave its fed funds rate at 0.00-0.25%, keep buying USD120 billion a month of bonds and stress that surges in inflation as the economy reopens will still only be temporary.
• But the Fed is also likely to discuss when to start slowing asset purchases and its forecasts may show rate hikes from 2023 rather than 2024.
• The hawkish tweaks are set to push Treasury yields back up, support the soft USD this week and temper gold. But the Fed’s overall dovish stance will keep benefiting risk assets this year.

This week the Federal Reserve will keep its very dovish stance despite consumer prices surprising on the upside as the US economy reopens.

Source: Bank of Singapore, Bloomberg

The first chart shows the Fed’s target measure of inflation - personal consumption expenditure (PCE) core prices - hit 3.1% in April, well above its 2% goal. Moreover, May’s core consumer prices (CPI) jumped to 3.8%, its highest rate since 1992.

The Fed, however, is set to leave its fed funds rate at 0.00-0.25% and keep buying USD120 billion a month of bonds. It will also stress that inflation rises will only be temporary as goods shortages ease, reopening demand for services settles down again and workers return to the labour market as jobless benefit top-ups end and schools reopen.

Source: Bank of Singapore, Bloomberg

In addition, inflation expectations remain anchored around the central bank’s 2% target. The second chart shows inflation expectations have stopped rising. June’s University of Michigan survey recorded 5-10Y expectations fell from 3.0% to 2.8%. 10Y breakeven rates have also declined from 2.60% in May to 2.34% now.

On a more hawkish note, however, the Fed this week is likely to start discussing when it will begin slowing its quantitative easing given the US economy’s strong rebound from the pandemic. But its taper talk will last many months with the Fed stressing that it needs to see ‘substantial further progress’ towards meeting its goals of maximum employment and stable inflation before it will slow its asset purchases. We expect the Fed will wait until as late as December before announcing it will start tapering in early 2022.

The Fed will also issue new forecasts as this week’s meeting. Its median interest rate projections - the average of its 18 current policymakers - may shift up to show rate hikes starting in 2023 rather than 2024. The hawkish tweak may not reflect the dovish views of the Fed’s leadership. But it is likely to support the soft USD this week, temper gold and push 10 Treasury yields up after sliding from 1.77% in March to 1.43% now (we see 10Y yields at 1.90% in 12-months’ time as the Fed tapers).

The Fed’s overall outlook, however, will remain very dovish this week. We expect its stance will continue to benefit risk assets throughout 2021.