As the markets have come to expect with each Federal Reserve policy meeting, the Fed resolved to leave interest rates near zero and continue the same pace of asset repurchases on April 28. In a departure to previous rhetoric that had left open the possibility of tapering asset purchases as the economy recovered, Fed Chairman Jerome Powell assured markets that the central bank would not be reducing its asset purchases anytime soon.
"He's certainly getting rid of tapering happening any time soon. He's slamming that door shut," Michael Schumacher, a bonds strategist at Wells Fargo (WFC, Financial), said. "It means that yields are a little less likely to go rocketing up. You're not going to get that wild card event where the Fed does talk about tapering fairly soon."
The latest reiteration of easy-money policy all but guarantees that we will see rising inflation numbers the likes of which the U.S. has not seen in over a decade, which is indeed the Fed's goal. It aims to maintain inflation moderately above 2% "for some time."
On the other hand, despite recent rises in inflation, higher employment numbers and many financial forecasters projecting anywhere between 4% and 10% growth of the U.S. economy in 2021, Powell maintains that it will actually be very difficult to achieve the Fed's higher inflation goal, with easy-money policy unable to keep up with the pandemic downside:
"It seems unlikely, frankly, that we would see inflation moving up in a persistent way that would actually move inflation expectations up while there's still significant slack in the labor market ... For inflation to move up in a persistent way that really starts to move inflation expectations up, that would take some time and you would think it'd be very likely that we would be in very strong labor markets for that to be happening."
Defining progress
"The economy is a long way from our goals and is likely to take some time for substantial further progress to be achieved," Powell said. "We expect to maintain an accommodative stance to monetary policy until these employment and inflation outcomes are achieved."
This brings into focus what exactly the Fed would consider to be "substantial further progress." Even though the Fed upgraded its outlook for the economy, its statements did not really provide any new information for markets, instead reiterating previous comments and factors that most consider to be inevitable developments, such as the ongoing economic recovery.
The Fed does not plan to pare back its bond buying, much less even begin to consider raising interest rates, until said "substantial further progress" is achieved. However, by this point it's pretty clear that this future progress will not be as simple as economic recovery in and of itself.
Adding money back to the economy
With the U.S. economy expected to see a strong rebound in 2021 as vaccination efforts continue and new Covid-19 cases decrease, it seems reasonable to expect that more money will begin to circulate again. The combination of the economic recovery with government stimulus efforts and the billions of dollars' worth of additional currency expected to be printed in 2021 in direct response to the pandemic will serve as upwards pressure on inflation numbers. The Fed's fiscal 2021 print order of 7.6 billion to 9.6 billion notes is an increase of 1.7 billion to 3.8 billion notes, or 30.6% to 65.9%, from the final fiscal 2020 order.
However, according to some analysts, increased inflation pressures will continue to be mediated by the same factors that have helped keep inflation low for years. Even with an expected economic boom, the aging population and an increasingly service-heavy economy could help mitigate inflation. Indeed, Powell said, "Inflation has risen, largely reflecting transitory factors," indicating that the Fed sees the recent spike in inflation as something that will peter out on its own.
The alternative
If the Fed is not expecting inflation to become an issue despite the combination of low interest rates, heavy asset purchases, record corporate debt levels and strong expected economic recovery, it almost seems like a situation that is too good to be true. The problem with situations that seem too good to be true, however, is that they almost always turn out to be exactly that.
As much as it reassures that inflation won't get out of control and the economy will recover, there is another important reason why the Fed is unable to raise interest rates or pare down its asset purchases: it is currently far less afraid of inflation than it is of the alternative.
Since the 2020 market crash, asset prices have been almost single-handedly supported by the Fed, both in terms of its asset purchases and the investor confidence that has resulted from the certainty that the Fed has their back. What would happen to the prices of the assets that the Fed has been buying if it were to suddenly withdraw its financial support? With U.S. corporate debt having surpassed 50% of gross domestic product and many companies only avoiding bankruptcy by being able to refinance billions' worth of debt at lower interest rates, equity markets would certainly be affected if the Fed were to begin backing out of these policies.
All things considered, it's no wonder that the Fed is being vague on what kind of "substantial further progress" would be necessary in order for it to begin paring back its easy-money policies. It will likely maintain such policies for years to come, not because it expects inflation to remain low but because it does not want to risk upsetting asset prices.
Disclosure: Author owns no shares in any of the stocks mentioned. The mention of stocks in this article does not at any point constitute an investment recommendation. Investors should always conduct their own careful research and/or consult registered investment advisors before taking action in the stock market.
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