Fed Holds Steady on Interest Rates But Shaves 2021 Economic Forecast

The Federal Reserve Board left interest rates unchanged Wednesday, while trimming its 2021 economic forecast and hinting that an end to its accommodative stance on monetary policy could come “soon.”

The move was largely expected. In December, officials said they would continue the bank’s $120-billion-per-month purchases of Treasuries and mortgage-backed securities, which have kept interest rates low and boosted the stock market.
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Now, the Fed says that, “Since then, the economy has made progress toward these goals. If progress continues broadly as expected, the Committee judges that a moderation in the pace of asset purchases may soon be warranted.”

That would be the first step toward an eventual hike in interest rates, which some members now expect could come in 2022 rather than 2023 as previously anticipated.
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The Dow Jones Industrial Average, which shedded 600 points to open the week Monday, staged a pre-meeting rally Wednesday, adding 400 points ahead of the Fed’s announcement. Shortly after the Fed statement, the Dow added another 89 points.

The Fed also cut its forecast for 2021 growth in the nation’s gross domestic product from the 7% it projected in June to 5.9% while boosting its 2022 forecast to 3.8% from 3.3% previously, reflecting an economy that has slowed as the delta variant of the coronavirus has forced new restrictions on businesses.

Officials also raised their projections for inflation with overall inflation running 4.2% this year, up from 3.4% in June. Core inflation, which excludes volatile food and energy costs, is forecast at 3.7% for 2021, compared to 3% previously, and 2.3% in 2022, closer to the Fed’s 2% annual target.

Fed Chairman Jerome Powell said the delta variant has had the effect of “slowing the economic recovery” through its effects on hiring and supply chain disruptions. That is largely the reason for the Fed’s reduced expectations for the economy’s growth in the near term and its increased projections for inflation. He said that industries such as vehicle manufacturing have been most severely affected by the inability to get critical parts like semiconductors in time.

“As the economy continues to rebound … these bottleneck effects have been stronger and lasted longer than expected,” Powell said.

Hovering over the Fed’s decisions is the current impasse in Washington over raising the debt ceiling. GOP leaders are threatening to withhold support for increasing the borrowing level, which has been done in the past on a bipartisan basis, raising the specter of a default on government debt. Few believe that would actually happen, as it would wreak havoc on the markets and America’s global reputation, but in the strained political atmosphere that prevails, nothing is ruled out.

“With this meeting behind us, the marketplace will shift over its focus to the debt ceiling debacle, something that seems like an avoidable, unnecessary risk being put on the market,” says Dustin Qualley, senior portfolio manager at Build Asset Management.

“My expectation is that pressure will intensify before any resolution is passed,” Qualley added. “The Treasury is already undertaking extraordinary measures to finance the government, suspending investments in certain government retirement funds. Should politicians fail to address this in a timely manner, consumer confidence will erode and risk assets could suffer. Putting the creditworthiness of the U.S. government in question because of political posturing is not only imprudent, it could have substantial negative consequences for investors.”

Standoffs over funding the government have occurred in the past and markets have recovered after initial sell-offs. A shutdown at the end of December 2018 lasted 35 days and prompted an 11% drop in the Standard & Poor’s 500 index before recovering by the time the shutdown ended on Jan. 25, 2019, notes Brian Gardner, a longtime Washington observer at Stifel.

But, Gardner warns, “Any sell-off related to the debt ceiling debate could be more prolonged. In the 2011 debt ceiling standoff, the SPX sold off approximately 18% starting in late July 2011. A budget deal to raise the debt limit in July 2011 was followed by a downgrade of the U.S. government’s debt rating in early August. The SPX experienced a volatile two months until it finally bottomed out in early October and then began a recovery whereby it recovered to its July levels in February 2012.”

While Gardner, Stifel’s chief Washington policy analyst, puts the chances of a government default as “still remote,” he adds that “the path to a deal is more murky than usual. “The political game of chicken could spook investors into a risk-off trade in the coming weeks.”

Indeed, even with the Fed poised to shift its easy money stance of the past several years, the market has yet to really price in higher interest rates, at least in the short term.

“Coming into the year, and into our 2021 mid-year outlook, we expected Treasury yields would move higher than current levels,” Lawrence Gillum, fixed income strategist at LPL Financial, said in a statement Monday. ‘Higher inflation expectations, less involvement in the bond market by the Federal Reserve, and a record amount of Treasury issuance this year were all reasons we thought interest rates could end the year between 1.75% and 2.0%.”

‘Now, however, there are two key elements suggesting we’re unlikely to see significantly higher interest rates by year-end,’ Gillum added. “The Delta variant’s impact on economic growth expectations and the continued demand for U.S. Treasuries by foreign investors are likely to limit the upside in long-term Treasury yields. As such, we are slightly lowering our year-end forecast for the 10-year Treasury yield. We now believe the 10-year Treasury yield will end the year between 1.50% and 1.75%.”

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