The Fed is committed to maintaining very accommodative monetary conditions and unchanged interest rates until the economy has returned to full employment and inflation has stabilised above its 2.0% target. But the Fed has so far been vague on what determines the pace of its asset purchases. It is clear that these will have to decline long before it raises its key rates. But when and on what basis? Tapering has its risks but also its benefits. The challenge for the Fed will be to steer a gradual steepening as history shows that steepening episodes can be quite abrupt and generate volatility on markets.
The recent upward movement in US longterm interest rates is mainly linked to the rise in inflation expectations and not to the rise in real rates. In a scenario where US GDP growth is expected to accelerate (5.2 to 5.7% in our central scenario in 2021, followed by +2.6 to 3.2% in 2022), real rates could adjust, as well. In this context, the Federal Reserve’s strategy will become a key parameter to watch, with implications on portfolio construction.
Since its strategic review, the Fed’s reaction function has changed. By targeting 2% inflation on average over a cycle, the Fed aims to anchor short-term interest rates at their current level. The FOMC has also committed not to tighten monetary conditions until the economy has returned to full employment (defined on the basis of multiple criteria, such as minority, woman or age group employment), and inflation prints are above target. Since June 2020, the Fed has bought $120bn of eligible assets each month ($80bn in Treasuries and $40bn in MBS). Its balance sheet is therefore growing at a rate of nearly $1500bn per year (7.5% of GDP). This balance sheet expansion is necessary to maintain very accommodative monetary and credit conditions via low long-term bond yields in the recovery phase.