By Tiffany Wilding, US Economist at PIMCO
Since the previous Federal Open Market Committee (FOMC) meeting in June, new data suggest that U.S. economic activity has slowed more than many observers initially expected due to renewed anxieties around COVID-19 and continued supply chain disruptions. Despite this, FOMC members signalled at September’s meeting their intent to announce the first reduction in the monthly pace of bond purchases as soon as the November FOMC meeting. The Federal Reserve also published a new summary of economic projections (SEP), which included a substantial upward revision to the Fed’s core inflation forecast for 2021 and a similarly substantial increase in the median expected policy rate through 2023.
The Fed’s new forecasts still imply an expectation that the currently elevated pace of inflation will fall back toward the central bank’s longer-term 2% target in 2022. Nevertheless, with above-target inflation appearing to be more persistent than many observers initially believed, members on the committee appeared to view a faster pace of tightening as warranted. Although longer-term inflation expectations currently appear to be consistent with the Fed’s 2% target, more persistent inflation likely raises the risk that inflation expectations accelerate higher, which in turn would warrant more aggressive tightening from the Fed. We believe the revisions in the September projections reflect Fed officials’ efforts to manage these risks.
Finally, on the bond purchases, even though the FOMC forcefully signalled its expectations for tapering starting in November, we see a risk that this is delayed until December. The U.S. Treasury debt ceiling is likely to become binding around the time of the November FOMC meeting, and the Fed may not want to further contribute to what is likely to be a period of elevated volatility. Nevertheless, the Fed can easily adjust the pace of tapering to still end purchases “around the middle of next year,” as Fed Chair Jerome Powell indicated during the press conference.
Economic impact of the delta variant and hurricane
Since the June FOMC meeting, a renewed rise in coronavirus cases from the more contagious delta variant has slowed activity in the services industry, while similar outbreaks in emerging markets have created more problems for suppliers and slowed production in the auto industry in particular. Production disruptions from Hurricane Ida also likely further exacerbated logistical issues, while damages, especially of vehicles, will likely augment demand and prices in the quarters to come, especially given persistent low vehicle inventories.
These issues also led PIMCO to revise down our outlook for 2021 U.S. growth and revise up our forecast for inflation. And although we continue to view the current bout of inflation as being driven by factors that should dissipate over the course of the next year, we’ve also become somewhat more concerned about longer-term inflation expectations accelerating further. According to the Fed’s Common Inflation Expectations (CIE) index, inflation expectations appear to be hovering right around the Fed’s 2% longer-term target. However, if a series of transitory factors (like the recent hurricane) produce more persistently elevated inflation, inflation expectations risk accelerating further, necessitating a more aggressive reaction from the central bank. While longer-term inflation expectations have not, as of yet, exhibited this type of behaviour, it’s a risk that the Fed likely wants to mitigate.