|By passing a $1.9 trillion fiscal stimulus package (8%-9% of U.S. GDP) on the back of a $900 billion package in December, the U.S. has positioned itself to have a strong growth recovery in 2021. |
This expected recovery in the world’s largest economy will have positive spillover effects on the rest of the world, including China, which has a strong recovery on its own as it looks to grow significantly above trend. Such an expansion by the world’s two largest economies should also be a positive for Europe, which has lagged in controlling COVID-19, and other small open EM countries, which have been helped by rebounding commodity prices.
A less helpful spillover from U.S. fiscal stimulus comes through a tightening of global financing conditions driven by the need, or even just the perception of the need, for tighter U.S. monetary policy. While higher yields, particularly real yields, do reflect improved growth outlooks, the concern is that the rapid recovery in the U.S. could lead to inflationary pressures that force the Federal Reserve to hike earlier than the current dot plot suggests. This brings us to today’s FOMC meeting.
With the Fed widely expected to keep rates unchanged, market focus will be on the summary of economic projections (SEP) and dots, Fed Chair Jay Powell’s tone and the Fed’s balance sheet.
Bottom line: This week’s Fed meeting will be one of the more important Fed meetings in some time. Powell will have to strike a delicate balance between a more upbeat outlook and the asymmetric flexible average inflation targeting (FAIT) reaction function — targeting a 2% overshoot means inflation is welcome. In essence, Powell will be trying to acknowledge a rate liftoff that is earlier than expected back in mid-December but later than markets currently have priced in. As for the U.S. dollar, expect it to benefit should the Fed meet expectations and continue its non-pushback on rising yields.
- SEP and dots: Revised forecasts will paint a more optimistic picture of the U.S. economy, and better forecasts equals a Fed closer to withdrawing accommodation. With the latest dot plot expected to still show less hikes than the market is pricing in, the focus will likely be more on the Fed’s shift in tone and possible signals for less accommodative policy that allows for further re-pricing of Fed expectations.
- Powell’s tone: The Fed chair is expected to signal that downside risks to the outlook have lessened and that risks are now more balanced. It is likely that Powell will underweight the output gap (GDP improvements from stimulus “sugar highs”) and overweight broad measures for maximum employment. A more upbeat tone, limited pushback on market hike pricing and reiteration that higher rates are consistent with fundamentals would give a green light to higher yields and vice versa.
- Balance sheet: No balance sheet changes are expected, but the Fed is likely to comment on market functioning issues in light of recent pockets of illiquidity. Based on past Fed comments, the threshold hasn’t been met for more aggressive U.S. Treasury intervention, but Powell will likely reiterate that flexibility is available in the balance sheet as needed. If asked about the tools the Fed has to adjust the balance sheet, expect Powell to avoid offering specifics and to simply reiterate that the Fed has the tools needed.
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