Jean Boivin, Head of BlackRock Investment Institute, together with Wei Li, Global Chief Investment Strategist, Elga Bartsch, Head of Macro Research and Scott Thiel, Chief Fixed Income Strategist, all part of the BlackRock Investment Institute, share their insights on global economy, markets and geopolitics. Their views are theirs alone and are not intended to be construed as investment advice.
The Fed surprised markets by embracing higher inflation and heralding a lift-off from zero rates in 2023, rather than 2024. We think this could add to its new framework’s credibility as long as last week’s fall in inflation expectations does not persist. Ultimately, the Fed’s outlook implies a more muted response to rising inflation than in the past. This and the economic restart keep us pro-risk.
Sources: BlackRock Investment Institute, U.S. Bureau of Economic Analysis and Federal Reserve, June 2021. Notes: The chart shows the range of actual core personal consumption expenditures (PCE) inflation levels that would be needed to make up for past undershoots of the Fed’s 2% target based on looking back at windows over the previous two and five years. The median projections for core PCE inflation for Q4 of 2021, 2022 and 2023 from the Fed’s Summary of Economic Projections (SEP) were 2.2, 2 and 2.1 respectively in March, and 3.0, 2.1 and 2.1 in June. The yellow lines represent the average of those projections in March and June.
The Fed has now made a meaningful upgrade to its inflation outlook by embracing a more pronounced overshoot of its 2% target. We view this upgrade as the Fed catching up with the restart dynamics. While the upgrade largely reflects the incoming data since the last meeting, there is a notable change: The Fed now sees the ongoing inflation surge as contributing to achieving its objective as opposed to focusing on its transitory nature. In addition, Fed officials now view the risks to their inflation outlook as having shifted to the upside. Even with the upgrade, their latest average inflation projection for the next three years only just sits at the bottom of the range of what could be argued to amount to a defendable make-up for past inflation undershoots. See the chart above. This new outlook opens the door to a 2023 liftoff in policy rates, something that was not possible under its March inflation outlook. This is still a much more muted response to inflation pressure than under its previous framework – or other major central banks’ current frameworks, in our view. It makes for a unique environment – we have called it the New nominal – that we see playing out in the next few years.
Some market participants have suggested the Fed’s shift to acknowledge higher inflation and pull forward its rate hike projections is evidence that it is already retreating from its new framework. We don’t think that’s the case. Instead, we view it as a reflection of more positive longer-term dynamics. The inflation outlook upgrade can now be argued to support a meaningful make-up of past misses, as the chart shows. This gives greater credibility to the Fed’s current policy stance in the context of its new framework. But it’s a minimum requirement. The new framework implies that if inflation falls short of the Fed’s projections – which are just at the lower end of the catch-up rates – the Fed might have to delay lift-off. The credibility of the Fed’s new framework could become challenged if last week’s downward move in inflation expectations were to persist. Overall, we see the new guidance as more balanced, with meaningful risks on both sides.
We had expected a 2023 liftoff, and the Fed now projects two increases that year – versus no liftoff projected in March. Yet markets are getting ahead of themselves by baking in three rate increases by the end of 2023, as indicated by the pricing of futures tied to the cost of overnight borrowing, in our view. We believe there is a limit to how much more hawkish the Fed can be given its inflation projections relative to the catch-up rates range. If expectations for a much earlier lift-off were to take hold, that would call into question the credibility of the Fed’s new framework and could lead to broader risk-off sentiment. The Fed has flagged it will start to assess the economy’s progress meeting by meeting, and this means more “live” discussion on the tapering of its asset purchases. We would not view taper discussions as a signal that the liftoff is getting closer, yet there is a risk such discussions could trigger market volatility or be miscommunicated by the Fed.
Our bottom line: We believe the Fed’s new outlook will not translate into significantly higher policy rates any time soon. This, combined with the powerful restart, underpins our pro-risk stance. Large cash balances held by investors and no obvious signs of financial vulnerabilities give us additional confidence. We prefer to take risk in equities and remain underweight bonds on valuations. Within equities, we have been warming up to cyclical stocks as the restart broadens globally, as reflected in an overweight call on UK equities and our upgrading of European equities to neutral earlier this year. We may see bouts of market volatility as markets test the Fed’s resolve to stay “behind the curve” on inflation. Any temporary spikes in rates could challenge emerging market assets in particular, but we advocate staying invested and looking through any turbulence as the New nominal plays out.
Market Updates
Past performance is not a reliable indicator of current or future results. Indexes are unmanaged and do not account for fees. It is not possible to invest directly in an index. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream as of June 17, 2021. Notes: The two ends of the bars show the lowest and highest returns at any point this year to date, and the dots represent current year-to-date returns. Emerging market (EM), high yield and global corporate investment grade (IG) returns are denominated in U.S. dollars, and the rest in local currencies. Indexes or prices used are, in descending order: spot Brent crude, MSCI Europe Index, MSCI USA Index, MSCI Emerging Markets Index, Bank of America Merrill Lynch Global High Yield Index, ICE U.S. Dollar Index (DXY), spot gold, J.P. Morgan EMBI index, Refinitiv Datastream Italy 10-year benchmark government bond index, Bank of America Merrill Lynch Global Broad Corporate Index, Refinitiv Datastream Germany 10-year benchmark government bond index and Refinitiv Datastream U.S. 10-year benchmark government bond index.
Market backdrop
Federal Reserve officials moved up their projections for raising interest rates, with the median expecting the first rate increase to take place in 2023, instead of 2024 in previous projections. U.S. bond yields rose and stocks softened. Economic data have been erratic, and we expect more of the same as economies restart amid pent-up consumer demand and supply shortages. We advocate looking through near-term market volatility and remain pro-risk, predicated on our belief that the Fed faces a very high bar to change its easy monetary policy stance.
Week Ahead
- June 22 – Philly Fed nonmanufacturing business outlook survey
- June 23 – Flash composite PMI for Japan, the euro area, UK and U.S.
- June 24 – Bank of England policy meeting; German ifo Business Climate Inde
- June 25 – U.S. personal income and outlays
Global PMI and other sentiment data will help investors gauge the status of the economic restart. The restart has been broadening out thanks to accelerated vaccinations. It has also created both supply bottlenecks and pent-up consumer demand, leading to volatile near-term inflation and growth data especially in the U.S.
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