The January meeting of the Federal Open Market Committee this week presents the central bank with an opportunity to reinforce its forward guidance, which is most likely not going to change for years.
At the same time, it will provide Federal Reserve Chairman Jerome Powell the opportunity to damp down growing market sentiment around inflationary risks that have resulted in a 29-basis-point increase in the Fed’s five-year, five-year forward rate – a key measure of expected inflation – over the past two months.
The Federal Reserve will keep its policy rate between 0 and 0.25 basis points at its January meeting. The central bank will not change the monthly pace of asset purchases of $80 billion in U.S. Treasurys and $40 billion in mortgage-backed securities, nor will it alter the overnight interest rate it pays against excess reserves.
Since we do not anticipate a change in the forward guidance on rates to occur until 2024, the primary emphasis of the statement will revolve around modest changes to the economic outlook linked to restrained economic activity and the December contraction in job growth.
The statement will reiterate the committee’s recent comment that the public health crisis “poses considerable risks to the economic outlook” and will not weigh in on fiscal policy.
We suspect that the main action will occur on Wednesday at Powell’s news conference, where he will reiterate the Fed’s outlook on inflation and explain how excess savings around the world contribute to lower interest rates and lower inflation.
In our estimation, there is a systematic surplus of financial capital relative to demand for capital investment. This is why interest rates and inflation have trended lower over the past four decades, well before the era of large-scale asset purchases by central banks, and will continue to remain low by historical standards.
We expect that Jerome Powell will explain how excess savings around the world contribute to lower interest rates and lower inflation.
Given that within a digital economy, the marginal costs of replication, access and distribution of services are driven to zero – which results in a surplus of services and consumer goods – the likelihood of a near-term increase in inflation or interest rates remains quite low.
We think that Powell will not miss the opportunity to dampen the market’s recent increase in inflation expectations. If not, given the expected improvement in relations between the Federal Reserve and the Treasury Department this year, we expect that incoming Treasury Secretary Janet Yellen will take the opportunity to reinforce this economic analysis. This will, in turn, have an impact on the evolution of inflation expectations.
In addition, we do think that a certain portion of public investors understands the commitment of the Fed to its flexible average inflation target (FAIT), which intends to let the economy run hot until it moves back to full employment, which we think is close to 3%.
The reiteration of economic analysis and policy framework should be more than sufficient to damp down growing concerns over the start date for the tapering of the Fed’s large-scale asset purchases – which we do not think will start until 2022 at the earliest – or a change in the policy rate that will not happen until at least 2024.
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