Overview
WHAT HAPPENED: In his speech at the annual Jackson Hole Symposium, Federal Reserve chairman Powell sent three key messages. Firstly, he confirmed that the test of "substantial further progress" on inflation has now been met and "clear progress" has also been made in the labour market. With the bar for tapering cleared, the Fed could begin reducing its asset purchases this year. Secondly, Powell stressed his view that the ongoing spike in inflation is transitory, while also acknowledging the possibility of wage rises shifting up inflation expectations on a more persistent basis. Thirdly, the strongest message from Powell today was to disconnect the tapering timeline from the interest rate lift-off timeline, following months of market speculation about the potential link between the two policies.
OUR INTERPRETATION: Overall, there was limited new messaging on the tapering timeline. Barring major data surprises, the September meeting will likely be used to send the initial signal on tapering, with the formal announcement on the timeline and pace coming later in the year - either in November or December.
By breaking the link between tapering and rate lift-off, Powell added some flexibility to the Fed's policy options after tapering is finished. This seems prudent not just because of lingering COVID-related uncertainty and its impact on the economy but also because of the uncertain effects of tapering itself on the overall financial conditions. Disconnecting the timelines of the two policy measures might have also united the Federal Open Market Committee members, given a sustained split between the more hawkish members who are ready to start tapering this year and hiking in 2022 and the more dovish ones who prefer to wait.
By explicitly acknowledging two different tests for tapering and rate hikes, Powell made a step towards further clarification of the flexible average inflation targeting (FAIT) framework. With inflation and labour market thresholds for tapering having been crossed, the tolerance for progress in both areas will be higher when it comes to raising interest rates. But how much tolerance the Fed can really afford will depend on whether - or rather when - the transitory view of inflation will be challenged.
OUTLOOK: We continue to expect the Fed to be cautious and measured in scaling back monetary stimulus, with the rate lift-off still unlikely before 2023. However, we believe that some inflationary forces, including wage increases, are likely to prove more persistent than the Fed currently anticipates. As these forces feed into inflation expectations, actual inflation could stay above the target for longer, testing the Fed's tolerance to overshoot under the FAIT framework. But before the transitory view gets challenged, we expect modest curve steepening and remain negative on duration in our tactical asset allocation decision sets, with a preference for higher yielding areas of the credit market.
