INSIGHTS

On September 29, 2021

Wall of Cash Meets Wall of Worry

The Federal Reserve (Fed) opened the door to announcing a taper in November, stating a “moderation in the pace of asset purchase may soon be warranted.”

The Fed is achieving its inflation target, but not employment mandate

Notably, inflation has cumulatively now exceeded the shortfall it suffered at the start of the pandemic (Figure 1).

Figure 1: Inflation has more than caught up for its 2020 slowdown

Source: FRED, September 2021. Personal Consumption Expenditure Index (PCE) is one measure of US inflation, tracking the change in prices of goods and services purchased by consumers throughout the economy.

However, despite the rapid initial recovery in employment, the current employment level remains over seven million jobs below its pre-pandemic trend (Figure 2).

Figure 2: Employment, however, remains well below-trend

Source: FRED, September 2021. 

So, although inflation has hit the threshold for tapering, employment has not.

The next jobs report therefore should be key. If strong enough, employment may well tip the Fed into a tapering announcement in November; a weaker report would make December more likely. Either way, we expect tapering will be announced by year-end.

Still no hikes anticipated until 2023

The Fed notably raised its inflation forecast from 3.4% to 4.2% for 2021 and from 2.1% to 2.2% for 2022, with inflation forecast to remain above its 2% target through 2024.

Nonetheless, the committee’s dot plot still reflects the majority of members not forecasting a rate hike until 2023. This indicates that the Fed fully intends to keep rates well below its current estimation of the long-run or neutral policy rate of 2.5% through 2024 (Figure 3). This is particularly noteworthy, considering the overshoot in inflation compared to the Fed's forecast during this time, underlining the Fed’s commitment to its flexible average inflation targeting (FAIT) framework, which seeks to achieve inflation that averages 2% over time and will allow inflation to overshoot after a period of undershooting.

Figure 3: The Fed’s dot plot implies policy rates will remain well below the long-run rate

 Source: Federal Reserve, September 2021

Eventual “lift-off” will be slow

We expect rates to lift-off in early 2023, in line with the Fed's forecast. We also expect the subsequent path of rate hikes to be gradual. Even after the unemployment rate drops below the pre-COVID-19 level of 3.5% (potentially by 2024 at its current pace) we would expect the Fed’s policy rates to remain below 2%.

In our view, this is a patient, data-dependent Fed that is fully committed to supporting the labor market to ensure as widespread a recovery as possible.

The risk to this outlook is inflation. If inflation surprises the Fed by proving sticky rather than transitory (as is our expectation, see Inflation Mission on Track), it could force the Fed to commence lift-off next year. On the flip side, unforeseen speed bumps could delay rate hikes. We may now be past peak accommodation, but likely quite a ways away from tighter Fed policy.

A key question remains as to whether a taper tantrum could occur once an announcement is made. We see it as unlikely given the Fed's clear guidance over the last few months.

Debt ceiling weighs on market nerves

Political gridlock outside the Fed remains a theme. Republicans are unlikely to support lifting the debt ceiling before the end of September. Unless Democrats agree to separate government funding from the debt ceiling, there could be a partial government shutdown at the start of October.

Our central case is narrowly for no shutdown, but the risk of a brief one is significant and rising. Still, shutdowns have happened in the past and tend to have limited market impacts.

A more severe scenario would be if the debt ceiling is not raised before the Treasury’s cash holdings run out. Hypothetically, this would likely occur around the last week of October. It could cause a technical default and lead to severe market disruption.

Democrats can amend the budget resolution and raise the debt ceiling in a party-line vote, but this would likely be a two to three-week process.

As the implications are severe, we believe that politicians likely will agree to raise the debt ceiling, but it appears unlikely before mid-October. As such, market nerves could well be frayed for almost another month. The potential for increased market volatility likely will rise as this timeframe narrows.

Separately, gridlock has also impacted the budget reconciliation bill, with passage unlikely before November. While there is a risk of no deal, we believe this bill is likely “too big to fail” for Democrats (equivalent to the 2017 tax cuts for Republicans). We expect the package to be $2 trillion or less but view eventual passage as likelier than not.

However, political challenges have increased concerns about fiscal policy becoming a drag in 2022, given less fiscal spending compared to 2021. The deficit is likely to shrink by $1.65 trillion to $1.25 trillion under current law. However, cyclical improvements will likely mitigate this to some extent. For instance, as the labor market improves, it should lessen the impact of the removal of expanded unemployment benefits. Additionally, municipal governments and consumers have saved much of the federal aid they received in 2021 and will likely spend it over future years – essentially delaying the economic benefit.

In our estimation that leaves the net drag from fiscal policy closer to $150 billion (Figure 4). This assumes the passage of a slimmed-down reconciliation bill. This would amount to 0.65% of GDP, in our view a manageable headwind for the economy, particularly as the inventory cycle begins to rebound.

Figure 4: The fiscal drag from a slimmer reconciliation bill may be less than it seems at first glance

Source: FRED, Insight calculations, September 2021

Wall of worry could mean higher volatility

Ultimately, we see an economy benefitting from still-accommodative Fed policy and excess savings on the sidelines ready to be spent. Furthermore, financial assets may continue to receive technical support from the “wall of cash” on the sidelines waiting to “buy the dips.”

In our view, we continue to see potential volatility as an opportunity to add to credit exposure in carefully underwritten securities.

CRN: 2021-0915-9464 R

The opinions and views of this commentary are that of Insight Investment and are not necessarily that of Advisors Asset Management.

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